Consumer prices jump 5% in May (CPI); this is the highest movement since 2008. What does this mean for interest rates? Before getting into the details, I can quickly tell you with 100% certainty, the only way for mortgage rates to go is up. Why are mortgage rates rising while the federal reserve pledges to keep rates low through 2023? How will this impact real estate purchases and refinances? What should you do now in a rising rate environment?
How are mortgage rates “set”?
First, it is important to note that the federal reserve does not directly control mortgage rates. The fed controls the “federal funds rate”. The federal funds rate is the rate at which banks and credit unions lend reserve balances to other banks and credit unions overnight. In a nutshell this is the rate banks get on the money they are holding in cash/reserves. Here is a more detailed explanation from Wikipedia .
So how are mortgage rates set? Unfortunately, mortgage rates are not “set”. There is no government or private party that can set rates per se. Mortgage rates are typically based on the 10-year treasury yield. So how does this work?
Before discussing rates, it is important to understand how bond yields work. The most important piece of this equation is the relationship between a bond price and its return. For treasuries, it is critical to note that a bond price and its yield move in inverse. What this means is that a higher bond price results in a lower yield and vice versa where a higher yield results in a lower bond price. For simplification purposes, I will not get into the full details of why bonds function the way that they do. Rest assured that it works this way and will always work this way.
With this key piece of information, we can now understand why mortgages do not move in direct correlation with the federal funds rate. This is now very apparent as the federal reserve has pledged low rates and yet the 10 year treasury just reached its highest level in over a year.
Why are mortgage rates rising now?
Long and short, the “market” is not believing the federal reserve that inflation will stay at historic lows and there is worry about the supply of bonds coming on the market from the recent 1.9 trillion stimulus coupled with talks of even more government spending.
- Inflation expectations: Market expectations for S. inflation rates have reached their highest levels in a decade, driven by a large fiscal package, progress on vaccine rollouts and pent-up consumer demand. The pent-up demand seems poised to raise prices while at the same time supply has become constrained on items like semiconductors. These two factors are driving treasury rates higher.
- Supply of bonds: The supply of bonds is getting allot less attention than inflation expectations but is even more important that inflation expectations. With the various stimulus bills enacted, the federal government is forced to sell trillions of dollars in new bonds to finance all these items. A good way to understand this is to think of a car lot, if you are going to buy a new car and there are three hundred on the lot, your chance of getting a better deal is greatly increased due to the supply. The same for bonds, as more bonds hit the market, the prices will decrease. Remember yields work in inverse to price so as prices decrease the yields will increase which in turn leads to higher rates.
Will interest rates on mortgages continue to rise in 2021?
Absolutely. Demand looks to take off which will spur inflation expectations while at the same time a firehouse full of bonds will be crushing the market forcing prices and in turn yields to increase. Treasuries have been on an upward march lately and this trend looks to continue and accelerate over the year. Mortgage rates will no doubt rise.
What do higher mortgage rates mean for residential real estate?
As rates rise, there will be two primary impacts on residential real estate. Sales will slow and refinances will come to a screeching halt.
- Sales slow: as rates rise, real estate becomes relatively more expensive as payments increase. Here is a chart of three cities based on the median home price how much the payment will increase:
|Median home price||2.5% rate||3.25% rate||Change in payment / month|
|Salt Lake City||$ 425,000||$1,679.26||$1,849.63||$170.36|
- Refinancing basically stops: As mortgage rates rise, the number of homeowners that will benefit from a refinance will drastically drop. Refinancing activity has already declined 38% in the last month or so as rates have risen. Look for the refi spicket to basically turn off as rates trend higher.
What do higher mortgage rates mean for commercial real estate?
Commercial real estate is valued primarily through the income approach. As rates rise capitalization rates also rise. Recall that cap rates work in inverse like bonds so lower rates equal higher values. For example, a property might trade on a 3 cap, with the rise in treasury yields maybe it trades on a 4 cap as a higher return. Here is a quick example assuming that income stays constant:
|Net Operating income||Cap rate||Value|
|$ 50,000.00||3%||$ 1,666,666.67|
|$ 50,000.00||4%||$ 1,250,000.00|
A 1% rise in cap rate will lead to over a 25% drop in value; think of an office building that has a loss of income and also an increase in the cap rate, the value of that property has plummeted.
Where will interest rates and in turn mortgage rates go in 2021?
When I wrote this article, rates for a 30 year refi were around 3.34%, this is up from around 2.75%. Based on the trajectory of treasuries, rates should end the year around 3.75% to 4%, this is still a good rate based on historical trends, but this would lead to about a 33% rise in mortgage payments which would price allot of prospective buyers and move up buyers out of the markets as payments rise substantially faster than income.
What should you do now with rising rates?
Unfortunately, the bottom in interest rates is over, the only direction is up. In the past, I’ve personally been a huge fan of adjustable-rate products on my personal real estate. As rates have stayed near historic lows, this strategy has worked out very well. Unfortunately, the world has changed with rates rising a certainty. Here is what I have done:
- Shorter term rates are still relatively low, as of this writing, I was quoted a 15 year fixed at 2.25%, this is still a historically low rate.
- If you do not have the cash flow to go with a shorter term loan, look into a 30 year fixed depending on your horizon for how long you think you will own the property.
I do not see rates going down in the next 3-5 years and likely longer with all the government spending and pent-up demand for products causing inflationary pressures. Furthermore, the federal reserve is basically at zero now so they will have very limited ability to influence a large drop in rates during the next recession.
Treasuries are flashing a warning sign that the economy will start running a bit “hotter” than the federal reserve is acknowledging. This in turn is leading to higher consumer and business rates from credit cards, mortgages, cars, corporate debt, etc… The higher borrowing costs will put the breaks on both commercial and residential real estate. There is no doubt rates are going higher, but the big unknown is how high. If rates rise substantially more than the market anticipates then all bets are off in real estate.
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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