FNC
Jonas Max Ferris
Signs abound that the six-year-old real estate rally is coming to an end. Those who think it can't bust without a huge increase in mortgage rates — something we haven't seen — should think again.

Tune in to FNC's Business Block, Saturday at 10am ET, for more with Jonas Max Ferris and the FOX News business team.

Major homebuilders like Toll Brothers (NYSE: TOL) and, more recently, KB Homes (NYSE: KBH) have warned investors about a slowdown in home sales. On February 13th KB noted a dramatic rise in cancellations and drop in orders in recent months. Toll Brothers stock is down about 50% from the highs of 2005.

Washington Mutual, among the largest mortgage lenders, just cut 2,500 people from their home loan workforce.

The median home price in formerly red-hot Southern California fell enough in January to wipe out six months of gains.

Worse, the supply of new homes is increasing as fast as new shares from initial public offerings of stock in the late 1990s. When I was flipping through The Miami Herald on the beach last week (within sight of a virtual skyline of cranes and under-construction condos — bubble ground zero) I read there are now 15,080 condo units under construction in the city of Miami. For comparison, during the last 10 years (hardly slow times for condo creation) there were just 11,241 units built in total. Then there are the 28,000 units approved for future construction.

Even those skeptical of the real estate gold rush say home prices can't dive without interest rates climbing sharply. At worst, prices are supposed to ease, not crash. Our new Federal Reserve Chairman, Ben S. Bernanke, just told members of Congress that a “moderate softening” was in the cards, not a “sharp contraction.” Since he is the most powerful figure in the world of interest rates, he should know.

The great real estate run of the past six years has carried many homes in the U.S. up over 100% in price — and some coastal and metro area homes up 200% or more. Real estate historically doesn't deliver such mouth-watering returns. Over long periods of time (not including the recent hot years) most homeowners have earned just a smidgen over the rate of inflation, which makes sense, as a home is really just a collection of commodities (land, lumber, labor, latex paint…).

For many homebuyers, interest rates are the key to how much they will pay for a home. How much home you can afford is really how much monthly payment you can swing. The fact that a home is $300,000, $500,000, or $700,000 is almost irrelevant — what can I buy for $3,000 a month?

As we've had historically low interest rates in recent years — notably short term rates which set the rate on adjustable rate mortgages — the typical home buyer has been able to afford far more home.

The median home price has gone up in lockstep with what the median household can afford to finance. If interest rates went to zero you'd be buying the very same home you would have bought with a 7% loan, only you'd be paying a higher price for it (yet for the same monthly payment!).

The logic goes that if interest rates go up, home prices will have to come down, as most people won't be able to finance a home at current prices. With no buyers, prices drop. While this is certainly true, it ignores the behavior of the speculator — an ever more important factor in the real estate market. By some estimates a full third of condo sales are to speculators.

Unlike ordinary homebuyers who plan on living in a home for a decade or more and will likely only sell if they are forced to (relocations, loss of employment), the speculator buys real estate to make a fast buck.

Real estate can be the ultimate fast-buck investment. Unlike stocks, somebody with good credit can buy a $1 million dollar condo with no money down, and just a few thousand dollars a month in financing costs — or rather carry costs — thanks to the new-fangled loans. If the condo climbs 20% in price in a year, they can sell for a cool $200,000 in gains (less broker commissions and other transaction costs) after only “investing” maybe $30,000 (or less) in interest payments during the ride.

Real estate has become a great futures market for these individuals. And unlike hot dotcom IPOs, you just need a high FICO score to play.

To the speculative buyer, the interest rate on the loan works differently than for the ordinary homebuyer. A traditional homebuyer can only buy, say, $3,000 a month in home, knowing they have perhaps $8,000 a month in household income. The speculative buyer's only concern is if the property will gain more than the cost of holding the property — the carry cost.

A speculator doesn't care if they can afford to finance the home for five or 10 years. If the rate on a mortgage doubles from 3% to 6%, a speculator won't stop buying until the expected return on the property is below 6%. A 10% mortgage rate is a good deal if your condo goes up 20% in a year.

The same phenomenon was noted in the late 1920s, right before the stock market crash. In John Kenneth Galbraith's classic, “The Great Crash 1929,” the author discusses troubles the Federal Reserve had trying to reign in rampant speculation in the stock market with borrowed money. Unfortunately, the only activity the Fed could stop by increasing interest rates was legitimate business activity — not speculation. To the stock speculator, whether a margin loan interest rate was 5% or 8% was irrelevant so long as stocks went up 20% a year. Today, the Fed faces a similar dilemma; increasing interest rates will stop car buying dead, not necessarily condo speculation.

According to the Miami Herald, currently about a third of new mortgages over $360,000 are interest only — the speculators' favorite, as these loans keep monthly carry costs to a minimum. The speculator could care less about paying down loan principal.

What may ultimately sink the housing market is not rising interest rates so much as flat to down housing prices, like we've seen in the last six months or so. With flat condo prices, even a 1% interest rate won't entice the speculator to buy — why lose 1% a year on an investment?

Interest rates may prove to be as important to current condo speculators as earnings were to former Internet stock speculators — which is to say, not very important compared to simple positive price action.

Unfortunately, the fat lady is singing at that opera.

Jonas Max Ferris is a regular contributor on "Cashin' In" (Saturdays at 11:30am ET and Mondays at 5:30am ET) and is co-founder of MAXfunds.com .