The Capital Trap

When you think about it, interest rates are the story in real estate now... and they are the story in the foreseeable future.

The current mini-boom in real estate sales/values is the artificial creation of the Bank of Canada's stimulus efforts.

The lowest central bank rate in history has Canadians back on the home-buying binge re-creating rising prices and multiple offers from the bubble years. All despite the fact that we are in the middle of the greatest recession since the Great Depression.

But it is these very interest rates that are dooming many buyers who are making the worst financial decision of their entire lives.

The Bank of Canada has lured them into a Capital Trap.

The first key concept here is that a house is only worth what someone can afford to pay for it. The second key concept is that very, very few people buy a house with cash.

The vast majority of real estate purchases are financed with mortgages-- with debt.

And credit is lent to homebuyers at a rate of interest... a rate that is currently at historic lows.

We've all read about the $2 trillion Federal deficit for this fiscal year and I have posted many entries about it. At the right is a US National Debt clock showing the exploding interest on that debt that the US government must service.

But that's only one element you have to consider. Every other government on the planet (yes, even the Chinese government as I posted here recently) is also anxious to borrow huge sums of money from someone to fund their exploding deficit spending.

Don't forget the corporations, local governments, agencies and real estate buyers who want to borrow money.

The point is: the demand for surplus capital far exceeds the supply of global surplus capital.

And as the voracious US government demand for debt servicing continues to grow, surplus money looking for a home is drying up even as the demand for surplus capital skyrockets.

The net result is interest rates will have to rise--and soon. While it is impossible to predict exact dates, simple laws of supply and demand dictate that rates will soon rise and will rise steeply as the shortfall between what governments want to borrow and what's available to borrow becomes visible (not to mention private demand for capital).

Most observers, which include the governor of the Bank of Canada (see post earlier this week), agree rates will double from the current market rate of about 4% to at least 8-9%.

Real estate prices can be set to whatever level the seller desires. However the value of a house will eventually settle to the price the buyers can actually afford.

And since since very, very few people buy a house with cash, when interest rates double, house prices will drop in half, regardless of any other conditions.

Interest rates are driving the buying frenzy/mini-boom now. And shortly interest rates will drive the market collapse.

Tomorrow we will discuss why house prices will be dropping by half in the very near future.

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