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A sudden rise in mortgage rates from 3.5% to 4.5% during the last 60 days has begun to skew the cost of buying a home. For every 1% rise in interest rates on a 30-year fixed, it now costs roughly 33% more over the life of that loan to get the same product you could buy in early May.

The dramatic spike has rescinded nearly half of the discount in mortgage rates (a la the Federal Reserve) that began in early 2009. If rates rise to 5.5%, the discount would be gone entirely.

The possible outcome in cancellations and reduced sales hasn't been lost on investors. Many of the homebuilders -- M.D.C. Holdings (MDC), Lennar Corporation (LEN), Toll Brothers (TOL), Brookfield Residential Properties (BRP), KB Home (KBH), D.R. Horton (DHI), TRI Pointe Homes (TPH) -- have fallen by 25%.

Let's consider a medium-priced 4 bedroom home in the California real estate market. The borrower needs a $410,000 loan. At 3.5%, the total interest on a 30 year-fixed loan would be $252,791; but at today's 4.5% it's $337,868, an increase of $85,077 in borrowing costs.

If rates continue to rise to 5.5%, the overall cost of that 30 year-fixed loan would be an additional $97,497 or $182,574 over the original cost of the loan at 3.5%.

These are some serious numbers. Is it any wonder that homebuilders have lost 25% since early May? The purchasing power of their buyers is being sapped.

Principal

Rate

Total cost (30 yrs)

Differential

Rise

Monthly Cost

Differential

Rise

$410,000

3.5%

$252,791

$1872

$410,000

4.5%

$337,868

+ $85,077

33.6%

$2112

+$240

13%

$410,000

5.5%

$435,365

+ $182,574

72.2%

$2367

+$495

26%

Further, if you scale in the one-year, 15% rise in home prices that's occurred in California, purchasing that home with a 30 year-fixed loan has risen from $410,000 at 3.5% in 2012 ($252,791), to $471,500 at 4.5% ($388,548) in 2013, a differential of $135,757, or 54% more in a single year.

Year

Principal

Rate

Total cost (30 yrs)

Differential

Rise

Monthly Cost

Differential

Rise

2012

$410,000

3.5%

$252,791

$1872

2013

$471,500

4.5%

$388,548

+ $135,757

54%

$2389

+$517

28%

2014

$495,075

5.5%

$516,879

+ $264,088

105%

$2811

+$939

50%

If mortgage rates rise to 5.5% as predicted by the end of 2014 -- and home prices increase another 5% from today's prices (less than predicted) -- the total cost for my example (above) increases by 100% when the loan is scaled up from 3.5% to 5.5%.

That will place a huge headwind before prospective buyers, and by relationship, the new-home builders. When this happens, today's much-touted "home-buyer affordability" could quickly dissipate, and with it, the strong recovery numbers we've been witnessing. Since the rate rise began, mortgage applications have fallen 5 weeks in a row, and refinancing has practically ground to a halt.

As it stands now, demand remains strong and supply is exceedingly low. But a continued rise in interest rates on the ten-year bond (from 3.5% to 5.5%) coupled with a 5% to 10% rise in the cost of homes, and suddenly those homes become out of reach for many families. It's just too much money in payments each month.

The current surge in the residential market is driven primarily by a lack of supply, followed secondarily by improved employment (demand) and historically low interest rates. Now that the exceptionally low rates appear gone, growth in the real estate market will be left to stand on its own legs, powered by jobs and a very constrained supply of homes.

Supply has become a serious demographic issue and it complicates matters for buyers, especially in land-constrained states like California where there is a chronic shortage of housing and very high occupancy rates. New home construction is only half the rate it needs to be in order to meet demand. Millions of construction workers were laid off during the 6 long years (2006-2012) when there was practically NO new construction; and now we are paying for it with a severe shortage in housing and skilled labor.

Added to this mix are the disincentivized sellers who either will not or cannot add to supply -- for example, the millions of homeowners who have refinanced their existing home at 3.5% and who might be loathe to relocate; and the 7 million homeowners who can't sell or refinance because they are underwater on their mortgages. Competition also cuts into supply: one-third of homes purchased are by cash buyers, and then there's another 10% of buyers who are investors.

New single family houses sold are running at the highest pace in 4 years; but the pace of those numbers is still coincident with the lowest levels in 50 years. And new single-family houses for sale are the lowest ever recorded -- nearly 20,000 units annualized below the previous lows in the late 1960s.

So supply is a serious demographic problem. Housing starts at 912,000 annualized have finally risen (after 4 years) to the lowest levels recorded in all previous recessions since WWII.

In retrospect, the years 2011-2012 were truly a boon for home buyers entering the real estate market. The 3.5% interest rates, record affordability, and home prices at 10 year lows were a once-in-a-blue-moon opportunity for those who had the courage to buy or the ability to refinance. They entered at the bottom of the cycle.

There is a large KB home community just north of San Francisco in Petaluma, CA, up on a hillside alongside the freeway. KB has been metering out the homes in this community for the better part of 3 years. Every so often I check in at the model home, look at the flyers, and discuss the pace of sales with the staff. Identical condos selling during the summer of 2011 for $350,000 are now going for $510,000, a 45% increase in price in 2 years. And they've had no trouble selling these homes because of strong demand.

American wages (when adjusted relative to the cost of living) have been flat for over 50 years. Yet families has been able to stay afloat through borrowing at low interest rates (read: refinancing of mortgage debt) and maintaining steady employment in a relatively benign, low-interest rate, low inflation environment. We are now a society based on low interest rates.

But if the bond market is indicating that inflated housing costs and higher mortgage rates are on the horizon, trouble lies ahead for middle and lower income families who are considering a home purchase. Many pre-approved buyers at signing may no longer qualify at the completion of construction. And there will be numerous cancellations, because the lead times needed for construction would not have kept pace with the rise in interest rates.

The bond market has effectively "priced-in" five (5) twenty-five basis point increases (25 bps). At the end of the day, price and monthly costs rule the qualification process for a home.

There's been a negative inverse correlation between the ten-year note and homebuilder shares this summer. Rates up 25%, builders down 25% (a 50% differential since May 6). If the rapid rise continues up to 5.5% on a 30 year-fixed product (say, during the next 12 months) and the inverse correlation remains in effect, the rise in borrowing costs could drop the share prices of the homebuilders another 25%, effectively cutting them in half since their May 2013 highs. Such a drop would also return the builders to their traditional valuation of 1.1 to 1.3 x book value.

The big question for investors in the homebuilder space is whether severely constrained supply and an improving economy will eventually trump rates and the growing list of disqualified buyers. Will there be enough new buyers left standing to pay the higher rates and prices? Will the banks replace their dying golden goose of refinancing with a relaxation in mortgage-lending standards?

History says yes, but as I noted above, another 5% rise in home prices coupled with an additional full point in interest rates is a big increase in the total cost of a mortgage in just two years (2012-2014). At some point buyers are going to rebel.

The Fed's desire to raise people out of negative equity by offering artificially-accommodative rates has spiked home prices and already created bubble-like conditions in supply-constrained markets. At 3.5%, you could have bought a lot of house, maybe too much house. A noted real estate commentator believes that the recent rise in rates is actually a positive, because it will cool the markets before they become a bubble.

My sense is that investors will pull back from the homebuilder space and look for moderation on all fronts. If the jump in rates is right, there's a much stronger economy on the horizon and the homebuilders will re-accelerate at the back half of the year on increased profits and backlog. If the rise in rates is premature, rates will begin to recede, which will stimulate sales for the home builders again. So either way, I think the long-term premise for the builders remains solid.

There might be an immediate cooling-off to assess the data -- to see if those 3.5% mortgage rates were a teaser-repeat of the First-time home buyer debacle in 2010 -- rates that pulled sales artificially forward to take advantage of an exceptional deal.

But if the economic resurgence and constrained supply is real, a quiet re-acceleration should appear as both prices and rates tick-up gradually. Then you have the best of all worlds for the builders -- sustained profitability and steady sales. For most of the last four decades, rates have stayed within a two-point band for each decade. If that holds true for this decade, our band is between 3.5% and 5.5%

A strengthening economy would also prove that the highly acquisitive ways of the builders these last two years was land-wise (they saw it coming); and their recent decision to conservatively meter out their land developments prescient.

That's why I especially like the CA builders (TRI Pointe, KB Home, Standard Pacific (SPF), Toll Brothers, Meritage (MTH)) and Brookfield Properties with its 104,000 lots. The forecast for CA home prices is a 20% rise in 2013 followed by an additional 13% rise in 2014 (Beacon Economics, Summer Report, 2013). Those are some heady numbers.

The gold market is clearly indicating that a sea-change is afoot in our economy, the kind that happens only at the beginning of a new secular bull market when investors abandon the yellow metal for a renewed trust in fiat economies. A similar thing happened in 1981, plunging gold into a twenty-year bear market. Historically, a recovering housing market has been the leading indicator for an economy on the mend.

Sustained demand for homes began rising when interest rates dropped below 5% three years ago. It escalated dramatically when rates dipped below 4% into the mid 3s a year ago. A total bargain in PRICE is what kick-started this housing recovery and made buyers into believers.

But now that time appears over, and we are back to the tipping point that first brought buyers into the market. It will be interesting to see what lies ahead in this suddenly uncertain market. Yesterday afternoon the Fed Chairman reversed his tapering comments and we now seem whipsawed back into "full stimulus" again.

After looking at this from every angle, my best hope is that mortgage rates stay between 4 and 4.5% for the foreseeable future (6-12 months), and any future raises be small and incremental, capping out around 5.5% at the end of the decade.

This gradual rate-rise would put a lid on the extraordinary price appreciation of the last 18 months and moderate the real estate market. If the economy is truly warming up, the housing market will recover -- even with the higher mortgage rates -- and with that, a more normalized pace in home price appreciation.

Mr. Bernanke has already accomplished his goal of stimulating the stock market to its previous levels through accommodative monetary policy. Corporate profits have grown steadily throughout his easing regimen.

The danger in prematurely stimulating the residential housing market is when the wages of middle-income workers (their profitability) does not justify artificially higher home prices. Without a greater redistribution of wealth into wages, I don't see how there can be a sustained rise in housing purchases by middle and lower income families. Thus the importance of moderate mortgage rates for the overall economy and home builder sales.

Source: Rising Rates Squeeze Home Builders And Buyers