Why Rising Mortgage Rates Won’t End the Housing Recovery

Why Rising Mortgage Rates Won’t End the Housing Recovery


Stock market investors may experience periodic fits of anxiety that the Federal Reserve will start tightening monetary policy, allowing interest rates to move higher. “Investors” in the real estate market haven’t been infected by those same jitters – but they seem to have caught them in recent days.

The average mortgage rate on fixed 30-year loans jumped last week from 3.78 percent to 3.90 percent, the highest it has been in a year, according to data released Wednesday by the Mortgage Bankers Association. Refinancing applications tumbled 12 percent – the third straight week they’ve fallen – and mortgage applications overall dropped 8.8 percent from the previous week.

Clearly, the prospect of higher interest rates has an impact on what happens to the housing market – and especially to housing prices, since as the cost of financing a home rises, consumers may become more cautious about how big a loan they are willing to take out and thus how much they’ll pay. That is probably particularly true today, as unemployment levels remain relatively high, wages show few signs of growth and consumer remain wary about over-extending themselves.

For now, though, home prices have continued to push higher over the last year. Tuesday’s S&P Case-Shiller data, the widely watched indicator of the health of both homebuyers and the housing industry, showed that housing prices in 20 cities nationwide rose 1.1 percent during March, on a seasonally adjusted basis – the 14th such monthly gain in a row, and a stronger performance than economists had been anticipating. It brings the gain over the last 12 months to 10.9 percent, the largest such annual increase recorded since 2006, when the market first began to show signs of stress. And the recent uptick in mortgage rates could spur some buyers to jump into the market before loans get much more expensive.

RELATED: Fear of Rising Rates May Spur Homebuyers to Act Fast

Those interest rate fundamentals are playing a kind of tug-of-war with another set of data: the rate of new household formation. For years after the credit crunch wreaked havoc on the housing market, this has been well below trend, even after accounting for the impact of the aging population. Everyone has experienced this first-hand or knows someone who has: an adult child who has returned home after losing a job or a 20-something without enough credit history to get a loan to buy a home. But household formation finally began to recover in 2011, when it rose by 1.1 million homes, and the rate hit 1.2 million in 2012. It may be belated and slow, but it’s steady. Even so, many of those gains have come on the rental side of the housing industry. Home ownership rates have increased only slightly from the lows hit in the first quarter of 2012.

Other indicators suggest that housing prices have higher to climb. New home construction is soaring and the average cost of a new home hit a record $330,800 in April, according to Commerce Department data released last week. Home builders are being cautious: They’re not flooding the market with supply but instead hoping to drive prices higher and compensate for all those years of dreadful performance. And we are heading into one of the seasonally strongest periods for home sales: the spring and early summer, when homes look most appealing and buyers are trying to situate themselves in a new home before the next school season begins.

The bottom line? You may not be able to fight the Fed, but it’s equally tough to battle a demographic trend. And as long as home ownership remains a prime political goal of the federal government and home owners are able to deduct their mortgage interest expenses against their tax bills, even higher interest rates may not take a big bite out of the long-term trend.

That isn’t to say that housing stocks won’t spend the next few  months in volatile territory, responding to each fresh headline about a Fed policy change. Many of them are sitting atop outsize gains in recent years: PulteGroup (NYSE: PHM), for instance, has seen its stock price soar 251 percnt since the beginning of 2012. With that kind of explosive performance behind them, investors will be wondering when to take their profits off the table, especially given that Pulte currently trades at nearly 30 times trailing 12-month earnings, roughly double the valuation of the broad market.

Indeed, despite the good housing data released this week, stocks like Pulte and Lennar – while in the black – are lagging the gains posted by both the Dow Jones industrial average and the Standard & Poor’s 500-stock index. It may not be time to dump these stocks, but it’s certainly time to stop chasing them higher and start to look around for other, perhaps more oblique ways to bet on the continued resilience in new household formation.

Paint companies, for instance. After all, whether you’re a homeowner, a landlord or a tenant, you’re likely to want to slap a fresh coat of paint on the walls from time to time, or to upgrade your property by putting in new kitchen cabinets if you can’t afford to move, or (if you’re a landlord) in order to charge a higher rent. Amidst the volatility and uncertainty that lies ahead, that is where the (relative) bargains are to be found.