Fluctuating Interest Rates

By John M. Lee

Ever since I wrote about the mortgage interest rates going up from 3% to 4.5% a couple of months ago and how that translates to the amount of real estate a buyer can purchase, I have been getting many questions on how that looks now that the interest rate is around 6.5 to 7%.

We did a little math with a hypothetical buyer at these parameters. At the beginning of the year, he is buying a $2 million home with a down payment of 30% or $600,000 and a loan amount of $1.4 million. With a 30-year mortgage loan at 3%, the monthly payment is roughly $5,900. Most people are stretching to purchase a home, so let’s assume that this is all the buyer can afford.

If we also assume that the $600,000 was in the stock market and 25% of that was lost, the down payment becomes $450,000. Since the interest rate is no longer at 3%; at a 4.5% interest rate and a payment of roughly $5,900, the buyer can only qualify for a $1.2 million mortgage. That means this buyer can only purchase a $1.65 million home, versus $2 million before – a 17.5% drop.

Fast forward to today and look at the same scenario at a 6.5% interest rate. With a $5,900 payment, the buyer can qualify for a $950,000 loan. Add that to the decreased down payment of $450,000 and that means that the buyer can only purchase a $1.4 million home, a decrease of 30%! If the buyer had liquidated his stock portfolio in preparation for the purchase and retained his $600,000 down payment, he can purchase a $1.55 million home, still a 22.5% decrease in purchasing power.

So, if we live in a simple and perfect world where the math dictates the outcome, we should be seeing a 22.5% to 30% drop in prices. However, real estate is complicated and other factors come into play.

What we will see, and are seeing at the moment, are fewer sales as buyers and sellers adjust to this new market environment. Having experienced this type of market three times in my career, here is what I believe will happen in the next few years.

At higher interest rates, buyers start to seek other options for their loans. Adjustable-rate mortgages are making a comeback. They might ask parents or relatives for more help with the down payment to help lower the monthly payments.

The number of sales will decrease as some buyers are priced out of the market. Owners with equity in their homes may choose not to sell the properties at these lower prices and wait for the next up cycle before selling. Owners who purchased or refinanced a home the last few years now own properties at a much lower interest rates and will not move unless they face a major lifestyle change.

Also, after the 2008 financial crisis, lenders had tightened up their underwriting guidelines and most people who purchased properties after that time period needed larger down payments, and have more equity in their homes. They will not be forced to sell like during the last crisis.

These factors will all help to limit the amount of price declines in our marketplace. Just keep in mind that we are a small seven miles by seven miles metropolitan area that is pretty much fully built out. And, despite the problems we have as a City, San Francisco is still a desirable place to live.

Zillow reported in mid-October that San Francisco Bay Area real estate prices dropped 3% from May to August of this year. The number will be larger when they next report the data as Zillow does not have the latest sales numbers. Will the price decline by 22.5 to 30%? I believe that the interest rates are about to plateau and that this 22.5 to 30% will be a theoretical maximum and I do not believe that our market will drop that far.

Our real estate market lags behind the stock market and is known as a lagging market indicator. Some people believe the stock market has reached its bottom and the feds increasing interest rates might be moderating. If that’s the case, the real estate market will decline a little more from this point before flattening out.

I hope these thoughts will help you if you are thinking about buying or selling real estate.

And one last thing: there is an important election on Nov. 8 that will affect all of us. Please go out and vote if you have not done so already!

John M. Lee is a broker with Compass specializing in the Richmond and Sunset districts. If you have any real estate questions, call him at 415-465-0505 or email at johnlee@isellsf.com.