Author: Izak Odendaal
Investment Strategist at Old Mutual Wealth
14 April 2022
Homeowners must prepare for higher interest rates
We all need to live somewhere and as human beings we tend to place a huge emphasis not just on having a house but having a home. It is always an emotive topic, and history shows that few things get people as animated as a bull market in house prices.
Unfortunately, history also shows that few things are as likely to cause a financial crisis as an overheated housing market (the other major culprit is excessive borrowing in a foreign currency). The 2008 global financial crisis (GFC) famously had its roots in low-quality (‘subprime’) US mortgages.
Therefore, housing matters for the real economy, financial markets and policymakers, and as interest rates rise, it is one of the key sectors to keep an eye on.
It is not just about whether housing markets will slow as interest rates rise, but also whether there has been a large build-up of debt among either households, banks or developers that can cause a major crisis.
Housing is in fact probably the main channel through which interest rates historically impacted the economy and, indirectly, inflation.
If interest rates go up, all else being equal, people spend a larger share of income on interest payments and there is less to spend on other things, putting downward pressure on prices.
When house prices rise, people often feel wealthier and spend more. The reverse is also true. Income growth of those involved in housing (from design to construction to sales) will also rise and fall with the housing market, with the same impact on inflation.
The same can be said for vehicle sales and other interest rate-sensitive items, but housing dwarfs them all. In the US consumer price index, for instance, housing accounts for a whopping third as actual rents paid by tenants and the implied rent homeowners pay themselves.
Working from anywhere
One of the major impacts of the Covid shock, unexpectedly, was to boost demand for housing as the link between work and physical location was broken.
Ultra-low interest rates helped of course. This saw house price increases across several markets, though in some (such as Sweden and New Zealand) it was just a continuation of pre-existing boomy conditions. In fact, in some countries and regions, rather than being welcomed, surging house prices have become a political issue as many feel they are excluded from home ownership.
Chart 1: Real house price indices
The US is the largest residential property market on earth with $17 trillion in mortgage debt tied to it, and housing activity has boomed. In particular, demand for houses (single family homes in American parlance) has soared relative to demand for flats (multi-family homes). Predictably, increased sales have led to surging prices and increased borrowing and construction activity.
However, prices, borrowing, and construction activity need to be seen in a longer-term context. Chart 1 shows that it took US house prices more than a decade to recover in real terms after the post-collapse. After peaking in 2006, household mortgage debt steadily declined relative to income. Homebuilding fell to multi-decade lows even though the population continued growing (chart 2). Such was the depth of the post-GFC scarring.
Indeed, that is precisely why financial crises are worse than mere recessions: economies usually bounce back from recessions, but after a financial crisis households, banks and companies can spend years cleaning up their balance sheets, lacking the confidence to take on any risk even when interest rates are low.
Chart 2: US housing starts and 30-year mortgage rates
At any rate, interest rates are no longer low.
US mortgage interest rates are generally linked to the 30-year government bond yield and not to the Federal Reserve’s short-term policy interest rates. Mortgage rates have therefore already jumped in anticipation of Fed hikes, rising to almost 5% from 3% at the start of the year. These rates are generally fixed when borrowers take them out, meaning existing homeowners won’t pay more, but new buyers will. With prices already high, it means affordability has taken a huge knock and this should slow activity. While a cyclical slowdown seems likely, there is still a longer-term structural underpin as the millennial generation, the US’s largest demographic cohort, moves into peak homebuying years.
Importantly, even if activity slows and prices cool, we are very unlikely to see a financial crisis.
Household debt is still below the pre-2008 level in real terms and the borrowing has mostly been done by households with high credit scores, unlike the infamous ‘Ninja’ (no job, no income, no asset) loans of the previous bubble.
Banks are well capitalised and generally much better behaved since the near-death experience of 2008.
The same cannot necessarily be said for Australia, Canada and New Zealand. While immigration is an ongoing source of demand in these countries, household debt levels are very high and rising and therefore vulnerable to interest rate increases.
Chart 3: Household debt to GDP ratios in selected countries
These countries, however, are not large enough to crash the global economy and markets. Only the US can do that, as well as China.
The Chinese property market experienced explosive growth in the past two or so decades. Until the 1990s, private home ownership did not exist. A market that had existed for centuries in other countries had to be created from scratch and then grow at breakneck speed to accommodate the estimated 20 million people that moved into cities every year.
Whenever there is rapid growth, all manners of excesses creep in.
In this case it was the increase in reckless borrowing among private developers, misallocation of capital (typified by the so-called ghost cities) and speculative buying by households. Growth can paper over most cracks until it stops. This is the trouble now faced.
In China, the headwinds are largely structural rather than cyclical since it is the only major economy along with Japan where interest rates aren’t rising.
The cyclical headwinds mainly relate to policy attempts to rein in debt levels and here the government appears to be backing off after several developers, notably Evergrande, have gotten into serious trouble.
Rather, the structural headwind is demographic. Around 90% of urban households already own their homes and since there are few other attractive investments (bank deposits offer negative real interest rates and equities are very volatile) many households own more than one property.
New demand for property will have to come from migrants from rural areas or children who start families of their own. Due to the one-child policy in place between 1980 and 2016, China’s population growth continues to slow, and its labour force is probably already shrinking. Both migration to the cities as well as household-formation by urban youngsters are likely to slow. What was once a massive tailwind will eventually become a headwind.
Whether this leads to a financial crisis in China’s tightly controlled banking system still seems unlikely (the global financial crisis was global in part because financial institutions across the world had exposure to US mortgage loans). But it does point to much slower overall economic growth rates in future than the 6% to 8% we’ve become accustomed to.
Investment in housing is estimated to be around 14% of GDP (much higher if related services are included). In comparison, at the peak of the US housing bubble in 2006 it was 6%. Unless some other source of demand replaces property investment, overall economic growth will slow as investment in property cools.
Chart 4: South African transfer duties
Homes at home
As chart 1 shows, house prices in South Africa have not grown in real terms in over a decade and remain below the 2008 peak (this is the nationwide picture and there will obviously be differences based on location, just as the performance of individual shares can differ from the broad equity index).
As in other countries, this partly reflects working off the excesses of the pre-2008 boom, but it also reflects subsequent weak economic growth and relatively high interest rates.
But like elsewhere, the local residential property market received a shot in the arm from lower interest rates and the work-from-home and semi-gration phenomena.
One way of gauging this is to look at transfer duties as reported by National Treasury. These have increased to a new record level. However, once adjusted for inflation, the true scale of the pre-2008 boom becomes clear, as chart 4 shows. Other metrics such as mortgage advances and building plans passed show the same picture.
In other words, while there is upward momentum in the local housing market, with positive spin-offs for related sectors such as lawyers, construction firms, retailers of building materials and furniture, it clearly is not a boom.
And since we have not experienced a housing boom, we need not particularly fear that a housing slowdown will crash the economy.
Still, the interest rate outlook remains key. The SA Reserve Bank (Sarb) is likely to continue raising the repo rate, which will take the prime rate to which home loans are linked higher. The question is how quickly and where rates will settle.
According to Sarb data household debt peaked at 80% of disposable income in 2008 and bottomed around 60% in 2018, a substantial deleveraging. Since then, it has increased somewhat. However, the portion of disposable income households spend on interest payments was at a 16-year low of 7.3% at the end of last year. It means that households can absorb both higher debt levels and higher interest rates, up to a point.
Other central banks are hiking quite aggressively. Money markets are now pricing in US policy rates rising to 2.5% by the end of 2022 and 3% by the end of 2023. This would be one of the quickest jumps in rates since 1994, though clearly rates would still be low by historic standards. For some emerging markets, interest rate hikes of 100 basis points at a time are becoming common. Given this, the Sarb is not going to sit on its hands, and it will continue raising rates even if our inflation outlook is much better than other emerging markets.
Bringing it all home
In summary, homeowners would be wise to prepare for higher rates, with an increase of around 1.5 percentage points over the next 18 months likely.
Meanwhile, the long-held view that housing is a risk-free investment offering exceptional returns has hopefully now been put to bed. Like all asset classes, it has its moments in the sun, but it also carries specific risks. Housing is subject to cycles, and house prices can fall contrary to the perception that rising land and building costs will always put a floor under house prices. In a downcycle, all prices can adjust lower.
As an investment, housing is illiquid and subject to high running costs.
The killer is that when a property is financed with debt, the debt stays the same when the value of the property falls.
South Africa has had a long residential property downcycle which might be turning for the better depending on the interest rate outlook.
This is good news, but your own home – your primary residence – shouldn’t be seen as a retirement investment since you will always need somewhere to live. It is a lifestyle asset, not an investment asset.
The original artical can be viewed here: