The underlying value of a share in a corporation is the discounted present value of its future distributable cash flow. Many things affect that value and they include, interest rate, competition, growth rate of earnings, predictability, the future expectations for the industry and the future expectation for the economy.
A house is like that too, but possibly with less complexity. Risk analysis requires that you know the future selling price within a range.
Suppose we say that the expectation for the neighborhood and the local economy are likely to remain the same. We can assume that the potential buyer is someone whose income is whatever the qualifying income is today plus inflation. Someone who can afford it according to the rules and would choose to live in this neighborhood.
What remains is the effect that mortgage interest rates have on value.
For a house that sells for $400,000 today, with 10% down and a 3% mortgage, the payment is a bit over $1,700 per month. With municipal taxes added and 30% of income as a limit for the total, income must be about $81,500.
Now lets jump ahead 5 years. With inflation at 2.5%, the salary will have grown from $81,500 to $92,200. If municipal taxes grew at inflation too, then the maximum mortgage payment would be $1,927.
But, what will interest rates be? They will define how big the mortgage can be.
If the interest rate is 5% then the maximum mortgage will be $331,000. With the same 10% down payment, the house must sell for $368,000. Other than the down payment being slightly smaller, in terms of share of income need to live in this house, nothing is different for the new buyer. To believe they will pay more is to believe that someone could and will allocate a bigger share of income to housing, or they will have a higher relative income than the original buyer or a larger down payment.
With selling costs and moving costs the original owner could retrieve about $31,000 of their $40,000 down payment. If they are buying another house that has fallen in value, or could sell without a real estate agent, they may not be worse for it.
At 6%, the future is less attractive. The house would sell for just $335,000. The vender would receive no cash from the sale. Selling costs and their mortgage balance consume it all.
At 7% there is a $27,000 cash deficiency.
What happens if you must stay because you cannot sell at those prices? The payment goes from $1,700 to $2,200 if the rate is 6%. Some part of lifestyle must stop.
What if you must sell? Very unpleasant in a 7% world.
We have experienced a housing market fueled by low interest rates. That cannot last forever. I have been a believer for about 7 years that rates will adjust immediately. Like the weatherman who predicts rain every day, eventually I will be right.
The moral is that housing is a difficult market. Like most other markets, values fluctuate. You must assess your ability to tolerate the fluctuation before you make commitments that you may find too onerous when things change. To fail to do so is to accept a risk that you do not understand and have made no arrangements to minimize should it appear. Unsound planning.
Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.