Monday, May 18, 2009

Hit the bottom or sitting on a trapdoor?

Curious times we're in.

We're hearing a lot of bluster, doom, gloom and just generally conflicting messages from all over the economy the last little while. Shouldn't really be surprising, we're in this massive economic fugue, and there is no consensus about what will come next so everyone is grasping at straws.

One day they're talking about green shoots and how the stock market has been rallying for weeks on end... the next the market tanks. One day you're getting all kinds of bravado from the realtors associations about how great things are and that the bottom is a thing of the past... the next there are reports the Canadian Real Estate Association of all outlets is telling everyone prices will be dropping through 2010 (truth be told, price wise, their predictions for Alberta in '09 and '10 were exactly the same as their February forecast).

Anyway, with the amount of shilling the media does for the real estate industry, sometimes it's almost nice to see their know-nothing cut-and-paste writers can get it so wrong both ways... would be nicer if they could get someone who actually knew shit from shinola and could write, but evidently it's that's not as profitable.

In any case, we've been witnessing what the bulls are claiming as a resurgence... really just a pretty typical spring. But I guess pointing out much the same thing happened last year at this time and prices still fell off the table in the fall doesn't get the gullible off their wallets.

What is different then last year is that we are actually approaching something resembling affordability. How can this be when six months ago prices were about the same but were considered very unaffordable?

In two words... interest rates. The governments have been slashing central bank rates to the bone, bond rates are negligible and finally mortgage rates followed. So, prices didn't need to go down to meet affordability... affordability rose to meet prices.

The question now is, are current interest rates sustainable in the long term?

If you think they are, perhaps we have reached a new balance and current prices will prove sustainable... but if you think rates are destined to rise, this so called bottom is nothing more then a trapdoor with another long hard fall for prices still to come.

What will happen? Who knows, there are far smarter and more worldly people then I that are completely lost trying to figure this economic situation. It's fairly safe to say that as long as the central banks rates stay so low, shorter term rates don't have much more room to go down, but we will likely see longer term rates continue to get closer and closer to their short term companions.

What I do want to take a look at is the impact of a change in interest rates has on financing. (Admittedly, I lifted this idea from a post I read on another blog, just to give credit where it's deserved)

Effects of Interest Rate fluctuations
Here we see how much one could qualify for on a conventional mortgage (25 years) given certain monthly payments. This shows us why with rates hitting these historic lows, suddenly the same amount of money can qualify one for a lot more money.

With rates at 3.5%, even as little as $1,500 a month will qualify a person for $300,000... back in November, the average rate was 6.51% and all a person with $1,500/month could qualify for was 222,000. As anyone who has every looked at finance could attest, that's HUGE.

Prices are largely the same (at least statistically, though asking prices still appear to be dropping), but in November $1,500 a month couldn't even buy an average condo... today, just six months later, it could probably get you a decent bungalow.

So, it's not hard to see why prices are holding at the moment. At these rates even a slight rise in price isn't out of the question. With interest rates getting so low, they have caused a massive increase in the buyers pool.

But, big but, the real question should be, can these rates hold for years if not decades. Cause if they don't, and start going back up, even to historically moderate levels like 6-8%, that buyers pool contracts in a hurry... and we again have severe unaffordability, and prices will again have to make up that gap.

And that's not the only problem...

Effects of Interest Rate fluctuations
To examine interest rates from another perspective, here we look at things from a post-purchase angle. The price is locked in, the principle is owed and now it's a matter of can those who bought when rates were low, survive rates going up when they renew?

Lets say a person bought a $350,000 home when rates were 3.5% and locked in for 5 years, so they're paying about $1,750 a month... come renewal, the question is, what will the rates be then and what will their payments be?

If they're at 6%... $2,250

If they're at 8%... $2,700

If they borrowed well within their means, and/or gotten some raises in the meantime, would still hurt a little, but they can probably swing it... if they leveraged themselves to the max though, they're in trouble. A 25%-55% increase in your largest monthly expense is not easily swallowed. And 6-8% is still at the low end of historical values, gawd forbid rates hit the double digits.

So, people thinking of buying today, just keep that in mind... and buy based on your needs, not just according to what the bank is willing to give you.