How "Free Money" Helped Create Sizzling Housing & REIT Gains In Recent Years

Housing prices and the associated REIT returns have worked very differently in the United States since the recession of 2001. The increasing financialization of the real estate markets by Wall Street, and the aggressive and unconventional interventions by the Federal Reserve over that time have combined in a multiplicative fashion to produce new and volatile sources of housing profits and losses.

One such change has been the creation of an extremely powerful profit engine for housing, that most real estate investors have not been taking into account. Indeed, there is a strong mathematical case to be made that "yield curve spread compression" has supported and enabled the substantial majority of housing price gains for homeowners and investors on a national average basis since the beginning of 2014.

Actual monthly gains in single-family home prices are shown in the yellow line above, and they climb from a starting point in January of 2014 to a national average gain of 31.3% by September of 2018 (based upon the Freddie Mac Home Price Index). This has been one of the most powerful real estate bull markets in history and has literally created many trillions of dollars of new wealth for investors and homeowners.

The blue line shows the percentage increases in housing prices that have been effectively enabled by yield curve spread compression. This created what could be called a form of "free money" that supported housing price gains during the time period examined, as home buyers could pay up to a 27.6% higher price to buy a house than they would have been able to - while not having to pay a correspondingly higher monthly mortgage payment (principal and interest only, and all else being equal).

Obviously, yield curve spread compression has not been the sole driver of housing price gains. There are myriad other factors including the underlying movement of short term rates, market and buyer psychology factors, and supply and demand factors in the numerous local markets that make up the national market.

The role of yield curve spread compression is that it has enabled the rapid growth of much higher housing prices than would have been the case without the compression. And as can be easily seen, the two lines have been tracking together with very similar slopes.

Through September of 2018, the 27.6% increase in home prices that is mathematically enabled by yield curve spread compression equals about 88% of the 31.3% in actual housing price gains. Comparing the two data series on a monthly basis, there is a 91% correlation between the theoretical gains in housing prices enabled by yield curve spread compression, and actual national average housing price gains during that time - which is a remarkably close relationship. 

Many people believe that the Federal Reserve creating a cycle of record low interest rates is what has created a cycle of record high real estate prices, and there is a great deal of truth to that - but it isn't the entire truth. The Federal Reserve changed the cycle to one of increasing interest rates in late 2015 and has been raising rates on a reasonably consistent basis since late 2016. Yet, real estate prices have continued their rapid climb, with almost 2/3 of the housing price gains since early 2014 occurring after the Fed began raising rates.

When we raise our sophistication level a notch and look not just at interest rates but at cyclical changes in the relationship between short and long-term interest rates (i.e. the "yield curve"), then we get a rich reward for our effort - a far better understanding of what actually changes mortgage rates, mortgage payments and housing prices in this financialized world that is often dominated by Federal Reserve actions. More specifically, we can understand what has freed up the cash to support one of the most profitable housings and REIT markets in history, along with the extraordinary rewards for homeowners, direct housing investors, and REIT investors.

That understanding is of particular importance at this time, because the current yield curve spread compression cycle is coming to an end, which has the potential to materially change - and possibly reverse - the recent cycle of rapidly rising home prices.

This analysis is part of a series of related analyses, an overview of the rest of the series is linked here.

Recap Of The Previous Analysis

The immediately preceding analysis in this series is linked here. It contains a detailed, step by step, exploration of what yield curves are, and the cyclical changes that have produced an average savings for home buyers in 2018 of about $3,000 per year. A graphically oriented recap of that analysis is below.

The graph above shows Fed Funds rates, Treasury yields and 30 year fixed mortgage rates over the period from January of 2014 through October of 2018. As can be seen, 30-year mortgage rates are generally priced at a spread above the 10 year Treasury rate.

The difference between interest rates of various maturities is known as the "yield curve", and the most common market measure of yield curve changes is the difference between 2 year and 10 year Treasury yields, which is the spread between the green and red lines in the graph above.

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Disclosure: This analysis contains the ideas and opinions of the author. It is a conceptual and educational exploration of financial and general economic principles. As with any ...

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