Last night I was watching some real estate show on HGTV with my wife.  My TV watching habits usually consist of either Basketball or Football, with little variation, so you can imagine the great sacrifice I made to hand over the remote.  :) 

AS usual, I'm always blown away by the prices people pay to live close to the inner city and the fact that a 2 bedroom 1 bath, 1000 SF, average looking apartment with no parking or garage will cost $500,000.  Where in Pocatello Idaho, $500,000 can buy you a beautiful 5,000+ square foot, 6 bed 4 bath, 4 car garage and an acre to boot.  In Pocatello, we see some differentiation from say the Highland area to West Pocatello, but if you found two similar quality homes with similar specs, the price would only be moderately impacted based on general area.  Specific locations can produce anomalies based on neighborhoods, (take for example N. Harrison in West Pocatello).  However, in Pocatello, we have regions that decrease value, but relatively few that would increase value substantially.  Perhaps the most prominent difference lies in the older homes very close to campus.  Values in this area tend to be well maintained due to both architectural styles and consistently high demand in the apartment sector from the University.  Though keep in mind that this does not mean everything in the area is a good deal.  Demand is never a lone determinant in establishing the quality or performance of an investment.

In bigger demographic areas, there are areas which in real estate we refer to as Central Business Districts or CBD’s.  Generally speaking the closer you get to the CBD’s the higher the value of land, therefore the greater the cost of real estate.  If we used land valuation as the determining factor for where CBDs are, in Pocatello, we would have a tough time finding it as land tends to be fairly equal from Chubbuck down to South Pocatello with slight variations.  This doesn’t mean we don’t have CBDs in our area, it just means we have multiple CBDs and that their demand area radius is fairly small.  In commercial real estate we call this a concentric rings model with the highest value of land usually being Yellowstone Avenue.

So why am I going into all this mumbo jumbo about valuations and Central Business Districts when the title of this blog post is on how interest rates going up will impact our market? 

Because the statement “there are no easy answers” is true in this case as well.  The analysis of CBDs and local markets is called a “microeconomic” analysis.  However when we look at interest rates, they have an impact on a much wider scale, and therefore have a “macroeconomic” impact.  So when you look at the impact of an interest rate, you can’t just look at how it will impact your “microeconomic” area and monthly payments, because macroeconomic aspects will impact all microeconomic centers, while the reverse may not be true.   Because costs of living differ significantly from area to area, increasing the cost of housing, which is the largest consumer cost across the board in all markets, the effect is magnified by each increase of a basis point (equivalent to 1/100th of a percent).

Example:

Area 1

   

Mo. Mtg Pmt

Annual Interest Cost

Avg Home Price

150000

   

Down Payment %

10.00%

   

Yr/Amort

 

30

   

Int. Rate

 

4.25%

($664.12)

 
   

5.25%

($745.47)

($976.27)

         

Area 2

       

Avg Home Price

450000

   

Down Payment %

10.00%

   

Yr/Amort

 

30

   
   

4.25%

($1,992.36)

 
   

5.25%

($2,236.42)

($2,928.82)

 

In an area where the cost of housing is low, a 1% (100 basis point) increase essentially takes $1000/household income out of the economy as each new owner arrives.  However, in a higher cost area, even though they may be paying for the same item, the increase of the cost is now 3x what the lower cost area person would pay.  As debt to income ratios are factored on pre-tax income, the financial impact on the largest cost area is significantly higher, which in turn will force more people to weigh the financial cost to benefit ratios.  The typical response is for them to move to areas further away from a CBD which will lower the cost of housing, but increase the inconvenience for them to get to work.  The key here is that if income does not increase at the same rate that they increase the interest rate, it will in a large economy, force home values to either slow in growth, or to regress and move in a downward price direction, until they reach a the fulcrum of the cost to benefit see-saw, which fulcrum is directly related to the interest rate and the variable costs associated with their moving. 

Fortunately most residential real estate terms are fixed over 30 years.  What this means is that as interest rates go up, the absorption rate of new interest rates will go down as people choose to stay put rather move due to the increase costs associated with moving and buying.  As the cost associated with doing so goes up, higher priced areas will react first as their cost of moving is highest. 

Generally speaking, when interest rates are low and property values are stable, that is when you should be buying homes and apartments for rent.  Assuming the population in a given area is increasing, as costs of ownership increase, including the cost of financing- then rents will have to go up to encourage additional investment into more housing and more housing has to happen to accommodate the needs of a growing population.  Even in the 80’s when interest rates were in the teens, some new construction had to happen to accommodate growth.  Which means people had to pay a premium and property values had to be kept low. 

Of course this is based on the assumption that property values remain stable.  The problem with the last recession was that the values did not remain stable, they dropped significantly, especially where housing prices were high.  Those areas that could maintain high demand of housing suffered the least (think Manhattan).  Florida, Arizona, Las Vegas on the other hand, where demand was more circumstantial than actual, suffered greatly due to the overdevelopment. 

You’re probably thinking at this point that I just refuted myself.  What I’m trying to do is show that a macroeconomic change on interest rates can have different effects on different microeconomic areas and that all factors need to be weighed when considering what will happen in each. 

So what is going to happen to the Pocatello area if residential loan interest rates go up to 6.5% and hold?  The shortest and simplest answer:  I don’t know. 

However, because people dislike the lack of conjecture more than they dislike inaccurate conjecture, here is my theory:

Assuming the average person has a rate of 4.25% right now, on an average home mortgage of $135,000, the annual interest cost for a new owner would be $2,270 more per year to own the same home.  The median household income in Pocatello in 2013 was $38,542.  So this cost in interest increase would take about 5.9% of their gross income.   Because I don’t think the median income has sufficient discretionary income to absorb this hit in one year, we would have to look at two other variables.  1. The median household income in Pocatello is predicted to go up an average of 3.75% per year for the next five years.  2.  The population is predicted to increase by .61% per year over the next 5 years (Below the national average of .71% by the way). 

I think the key indicator is how fast income is anticipated to rise.  Nationwide, the estimate is 3.03%.  So we’re slightly ahead of the national average.  In turn, this means that as long as the increase happens gradually and census predictions hold true, (over 18 months to be exact), home value should stay steady with the same buyer being able to buy the same home throughout.  If they jump faster, prices may go down.  If they go slower, say they take 5 years to get to 6.5%, then home prices should continue moderately increase in the Pocatello area and this is reasonable in my opinion.

Now for other higher cost areas, the problem is that the average home owner needs to already be making an average of 3 times the Pocatello household (which few do) and have to maintain a similar percentage growth in income.  (Yes, this means a widening of the gap between income classes, but that’s not my point.)  The point here is that if income growth slows in a more costly microeconomic area or if the balance between cost of housing and income becomes too lopsided, that area will see another correction in home values.  Look at Detroit for a great example of this.  Detroit lost a lot of good paying jobs from the automotive industry when auto sales slowed down, lowering their median household income.  Even though interest rates stayed steady, the rest of the cost of living did not and as income decreased, home values plunged causing a further exodus of population away from the city, which in turn hurt demand and lowered home values even more.  In the end, cities near Detroit were bulldozing entire neighborhoods to get rid of supply so they could reach a supply and demand ratio that they could recover from and start growing again. 

Bottom line:  If you live or own property in Pocatello, we’re looking good compared to most of the country when accounting for an increase in interest rates.  Especially because I think they will go slowly, mirroring the health of the economy. 

Action Item: What does this mean for you? Go out and buy real estate in the Pocatello area.  Be smart about it and buy stuff that will cash flow, but as long as appreciation doesn’t go over 3-4% in a year, we’re probably going to do quite well.