First Some Basics    

Via a monetary policy called Quantitative Easing, the Federal Reserve has been the primary purchaser of mortgage backed securities since 2008.    This tool is in addition to their traditional lever over the discount rate.     The Fed buying vast quantities of mortgages is the primary reason that mortgage rates have been so low, falling from an average of 6.03% in 2008 to 3.66% in 2012 (data).  

The Path to Higher Rates

Last week, the Fed roiled markets globally by signaling that their bond buying binge was nearing an end.    The Fed has since reiterated that this was not a change in policy, but the markets thought otherwise.    Rates jumped overnight on everything, including mortgages.   Traders rejoiced, they love volatility.


As I’ve advised clients and discussed at the Boulder Real Estate Meetup, I expect the current period of abnormally low rates will end sometime in the next 18 months.  The path to higher rates will likely be characterized by high volatility as traders fuel overreaction and take their profits.  The Fed’s activities are not an on/off switch (think of it more like a gas pedal) but speculative activity by traders will lead to short term volatility.     


From A Hawkish Signal Bernanke Didn’t Send (WSJ):   
Mr. Bernanke said that if the economy unfolds as the Fed expects—and he emphasized the “if”—it would reduce later this year the size of its purchases of Treasury and mortgage-backed bonds, currently at $85 billion a month. He said the plan is to cease the bond purchases, known as “quantitative easing,” in mid-2014 if “subsequent data remain broadly aligned with our current expectations” that unemployment will fall to about 7%.


He repeated the vow to keep short-term interest rates near zero “at least” until unemployment falls to 6.5%, probably not before 2015.

Southern Sun vs. Frasca:  The Impact of Higher Rates

The following charts are based on a fixed rate 30 year mortgage.   

Assuming a $400,000 plain vanilla mortgage, a quarter point is equivalent to about $55 to $60 per month.    That’s a dinner for two plus a pint of FYIPA at the Southern Sun each month.   The difference between 3.75% and 4.00% is $687 per year, significant to most buyers of homes priced below $500,000.

Assuming a $1MM plain vanilla, fixed rate mortgage, a quarter point is worth about $140 to $145 per month.     That’s a dinner for two at Frasca, a bottle of wine, and maybe a shared dessert each month.  The difference between 3.75% and 4.00% is $1,716 a year.     How significant is that to a affluent purchaser? Far less meaningful but possibly still a factor.  


The typical borrower of $400,000 is running a far tighter monthly budget and rising rates will have a greater impact on the real estate market at the entry level.     The entry level also happens to be the segment of the market with the least inventory and the most potential buyers, resulting in bidding wars on anything even remotely desirable.    How much do you think it will cool during the next twelve months?     Probably not much. 

Constant bidding wars are new to Boulder Real Estate but the underlying fundamentals of supply and demand at the entry level are not new.    Low rates and a increasingly healthy economy are just adding fuel to the fire.   During the entire economic downturn, the Southern Sun had no shortage of customers, just like the entry level of the Boulder real estate market.    

Osman’s Crystal Ball

My crystal ball says higher rates are coming, which will slow the market, but it probably won’t be noticeable for houses priced below $500,000.   Above that price point, the market is more driven by broader measures of economic performance like the S&P.    If we see a sustained drop in equities markets, it will cool things off noticeably for luxury homes.      


If you’re a buyer, I recommend beginning the process of shopping for a mortgage early and lock your rate on the dips.    There will be occasional negative economic news causing rates to plummet for a day or two.   That’s your opportunity.    One of my buyers is actually exploring an 11 month rate lock (the current delivery date of new construction at Anthem Ranch).      


Location risk is something you should add to your analysis.  The best locations tend to rise faster and fall slower during real estate cycles.    If you’re concerned about the soundness of your investment, I recommend minimizing location risk even if it means buying a fixer or a less than ideal house.    Both Boulder and Louisville are very active, highly desirable markets.  Although bidding wars are occurring everywhere on the front range, these two markets will probably hold up better during the next real estate cycle, with Boulder having the better track record.   Within these two markets, there are also locations that did better than others.    Talk to your favorite Realtor for more granularity. 


Finally, rapidly rising prices are an important factor to consider. Two years ago, most entry level ranches were still selling for about $375,000.     Today, basic ranch prices in good condition are above $400,000 (if you can find one) and will likely accelerate further before the summer is over.   


The higher end has also seen a record number of closings as buyers flooded into the market.   It’s harder to analyze the appreciation at the higher-end (you know I hate to ballpark), given the diversity of housing types, but gains are clearly occurring there too.  It’s the old “you know it when you see it” rule.  See Record for $1MM+ Homes in Boulder. 

—