Big Homes, Big Loans and Rising Interest Rates

“Toronto Sees Surge in Sales of Million-Dollar Starter Homes,” reads the recent headline in the National Post.

The article in the Canadian paper goes on to say that 222 homes sold in the greater Toronto area in the first quarter of this year for over $1 million–a fourfold increase from the same period in 1999.

I found an agent’s comment in the article amusing. He said, “Forget about getting some sort of mansion. You can’t get that for a million dollars anymore.” Lots in upscale areas are going for a million. The same agent said, “People are buying old homes there for $1 million, tearing them down and putting up $5 million homes on them.”

While Re/Max and Royal LePage, two big Toronto real estate brokerages, said many of the buyers are Baby Boomers who inherited money, the banks are telling a different story.

CIBC, one of the six largest banks in Canada, said it has placed a record number of $1-million mortgages so far this year.

Personally, I believe that only a small number of people are buying high-end homes with cash. In talking to my contemporaries, I would say 5% to 10% of the high end homes, at the most, being bought today are being paid for in cash.

Unfortunately, we live in a society where a consumer’s expenditures are a direct relation to that consumer’s income. It’s still “the more you make, the more you spend.” In fact, because interest rates are so low, this adage has probably never been so true.

With variable rate mortgages, a $1-million mortgage carries for less than $40,000 in interest payments per year. So if a professional is making $200,000 to $300,000 a year, the $40,000 mortgage payment can be accommodated.

The robust luxury housing market is not restricted to Canada and the U.S. In the United Kingdom, luxury housing prices are also out of control.

What will cool the housing market? Likely the most sensitive sector to interest rate movements is the real estate and construction sector. Higher interest rates will hit the high-end market much quicker than the low-end housing market.

A two-percent increase in interest rates on a $200,000 mortgage is only $4,000 extra per year. But going back to my example of $40,000 in annual interest payments on a $1-million mortgage, we are talking a $20,000 increase in annual payments if rates go up two percentage points. A $20,000 annual increase in carrying costs is a larger number to digest even for a $200,000 to $300,000 income earner.

In the U.S., the question is no longer whether the Fed will increase rates, but by how much.

The Bank of England has increased interest rates twice since November-its benchmark rate is now 4%, up from a 48-year low of 3.5%. Most economists feel The Bank of England will raise rates another one-quarter point this month. Since most mortgages in the UK are variable rate, the increased rates will result in higher mortgage payments instantly.

And this is likely why Tony Dye (you may remember him as Dr. Doom for predicting the 2000 tech crash) said last week that he expects UK housing prices to fall by 30% by the end of this decade.

I think it’s risky for an economist to make a prediction on housing prices six years out, as Mr. Dye has. And I really do not believe the low-end, first-time, suburban house buyer will see his or her home fall in value much if rates do rise only a point or two.

It’s the high-end, million-dollar home market that will quickly feel the pain of higher rates. And it won’t be pretty.