KB Home (KBH), The Home Depot, Inc. (HD), First American Financial Corp (FAF): Higher Mortgage Rates Could Revitalize Smaller Home Sales

It’s a billion-dollar question: Following a 30-year bull run in bonds and falling interest rates, can the housing market survive a rising-rate environment?

Rising rates have a direct impact on housing affordability. Mortgages at a 5.5% annual rate are 12% more expensive than at a 4.5% rate. At 6.5%, monthly mortgage payments are nearly 25% more costly than at 4.5%

As rates go up, the amount a buyer can afford to spend on a home goes down, all else equal. But will it put a damper on a real estate recovery?

The great American upsizing
Bond values weren’t the only thing going up over the last 30 years. Data obtained from the U.S. Census shows the average newly built American home swelled in size, too. The average home built in 1975 was 1,535 square feet. By 2010, the average build came in at 2,169 square feet.

What’s behind the meteoric rise in home sizes?

Interest rates could be to blame. In fact, when you look at a chart of home sizes by year, they seem to be inversely related to interest rates.

As interest rates fell in the late 1970s, home sizes grew. As rates rocketed in the early 1980s, home sizes contracted. After reaching a peak in the 1980s, mortgage rates have fallen precipitously, and homes have grown in almost every single year since.

The great downsizing
The question to ask ourselves is whether the future American home will look anything like the homes built in the last 10 years, when interest rates were almost always treading on record lows.

I’m not entirely convinced that rising rates are the end to rising home values across the spectrum. Americans have largely forgotten that a home built recently is some 40% larger than a home built in the 1970s. There isn’t a real, practical reason for the shift. We’ve just become accustomed to more space for the same number of people.

Many people could afford to live in smaller homes. Following the financial crisis, apartments added new tenants quickly. Vacancies fell to 4.3% in July, according to The Wall Street Journal. While it’s likely renters feel cramped in smaller apartments, it’s unlikely future homebuyers will need a subprime boom-style McMansion after moving out of a rented apartment space.