MASTERWERKS LLC BUILDING SERVICES Custom Home Building, Transformations, Renovations
Thoughtful Analysis & Measured Advice
A little context, intended to ease heartburn over current interest rate hikes:
Over time, rates have naturally averaged just under 8%.
The low interest rates of recent years were a historical aberration.
April 22, 2022
Strategizing in an Unpredictable Housing Market
As you’re no doubt aware, interest rates are on the rise, as the Fed reacts aggressively to curb surging inflation. More increases are in the offing, but how far and how fast the acceleration will move is anyone’s guess.
For some years now, homeowners have enjoyed the luxury of historically low interest rates, with many people now accepting them as the norm, coloring their expectations. Combined with increasing demand for limited housing stock, these lower rates have triggered higher home prices. As a result, we now have elevated prices and rising rates, constraining opportunities for home buyers.
Rising Interest Rates Shrink the Buying Pool for All Homes
Since higher interest rates limit people’s ability to qualify for larger mortgages, the combination effectively shrinks the buyer pool for homes in all price brackets.
Case in point: Edina’s average sale price for all single-family homes is now over $1M, with average new construction costing $2M or more. At those prices, a rise in interest rates of 1 to 2% can quickly slow demand and reduce the number of home sales, even for a more affluent demographic.
When rates rise, the amount you can borrow for a particular payment drops. When the approved mortgage amount is smaller, the difference must be
paid in cash or else the transaction gets canceled.
The 2007-2009 Housing Crisis:
Caused by a Different Set of Issues
During the “Great Recession” of 2007-2009, the meltdown had less to do with an increase in interest rates than with lenders suddenly tightening qualifications and restricting popular stated income loans, colloquially called “liar loans” because borrowers were required to provide only limited documentation, especially on income. When lenders began to realize the extent of their potential exposure, they slammed the brakes on lending, and the buyer pool shrank rapidly.
Underlying the crisis were those previously loose mortgage qualifications, with low down payments and adjustable-rate loans. Many homeowners who had bought houses—sometimes multiple properties—they couldn’t really afford were under water as prices declined, unable to sell at price points that would pay off their lenders and recoup their investments. This dynamic led to the foreclosure/short sale boom.
Today we have different circumstances, with the restrictive monetary policy—rather than tightened mortgage qualifications—set to trigger a contraction in the housing market.
Unlike the previous debacle, lenders have learned from the recent past and require more restrictive qualifications, larger down payments, and are issuing very few adjustable-rate mortgages. Recent price appreciation has also led to equity gains, leaving today’s homeowners in a far stronger position, making it doubtful we will see a repeat of 2007-2009.
Playing It Safe: Homeowners Shift to Remodeling
During the recent pandemic lockdowns, remote work, and school closures, people had more than enough time to focus on the drawbacks of their home environments. As individuals and families struggled to adapt and correct shortcomings, many examined their options, weighing the costs of replacing their homes or embarking on more expensive new construction.
After factoring in real estate fees, moving expenses, and general disruption—not to mention the fact that affordable replacement homes also tend to require significant modifications—many people have decided to stay put and remodel. Better the devil you know than the devil you don’t, in effect.
Aiding the current remodeling boom is the growth of home equity, fueled by inflation. By tapping their equity to finance improvements, homeowners see an opportunity to rectify the limitations of their current homes. Intelligently managed, that decision can pay off at lower overall costs and, in fact, greater potential for return.
Over the past six years, Edina has seen an escalation in housing prices. Inflationary spikes are currently affecting the cost of new construction.
So, How Bad Will the Housing Market Get?
As usual, opinions about the likely severity of the contraction are all over the map, with “experts” predicting everything from a crash of 25% or more to a safe landing, due to the influx of institutional speculators investing in single family homes. (In passing, that’s a strategy that did not work out for Zillow, which is now attempting to sell off its house-flipping enterprise.) No one really knows how seemingly disconnected events such as COVID, inflation, shortages, the invasion of Ukraine—as well as other crises yet to manifest—will affect market demand.
Certainly, we are already seeing slowdowns in the new construction market, subjectively due to rising rates and inflation causing costs to accelerate. Additional rate hikes will likely exacerbate the situation without reducing actual building costs.
The prognoses we hear in the news reflect national trends across a wide swath of diverse housing markets. Markets are not uniform, and there are great differences among and within metro areas. Gleaning pertinent information requires a laser analysis of community—or even neighborhood—patterns. Each has its own characteristics, and sales results can fly in the face of wider predictions.
Consider Edina, for example, long a magnet for higher-income residents. This affluent community presents housing statistics that are markedly different from its neighboring areas, with their less predictable patterns around sale prices, interest rate sensitivity, and housing demand.
The above charts demonstrate the clear, inverse relationship between
falling interest rates and rising prices.
Playing It Smart:
Feasibility Analysis First & Foremost
Before jumping into any specific remodeling project, it’s best to take an informed look at your entire property, which has a market price composed of two parts: site value and structure value. The structure is a depreciating asset, reflecting the ideas of the era in which it was built or significantly remodeled. Over time it suffers physical, economic, and functional obsolescence. Meanwhile, the site value rises as the structure value falls.
There are many causes for this inverse ratio, including the wear-and-tear of daily living over decades; lack of improvements and reinvestment, perhaps due to other priorities or investment needs; and a lack of effort or unsuccessful efforts to increase or maintain market-relevance. Without investment or mitigation, the value of the house eventually becomes a negative, where a potential purchaser gauges only the cost of removing the structure and recycling the land.
To avoid losing money when the time comes to sell, MasterWerks requires and performs a feasibility study before embarking on any major home improvements. The goal is to find the budgetary sweet spot for making updates, while avoiding misguided “improvements” to the structure, which could then result in a property that is significantly lower in perceived value in relation to other viable options within its competitive market tier. Instead of wildly overshooting the mark—an all-too-common mistake with remodeling—our goal is to position your home to compete effectively as the best in class, enhancing future resale potential.
Protect Equity by Reinvesting Shrewdly
As a rule of thumb, the best homes—intelligently designed, updated, and in good condition— always sell, because even if the market stalls, their maintained market-relevance provides equity protection, which is less true of the also-rans. When prices and rates rise, buyers are increasingly drawn to existing housing stock that’s been improved with new kitchens, baths, updated exteriors, floor plans, energy-efficient windows, insulation, and heating, ventilation, and air conditioning (HVAC) systems. These higher-caliber homes are viewed as cost-effective alternatives to new construction, because for many reasons, few buyers are interested in taking on projects. They seek completeness and relevance: the more, the better.
Depending on which strategy the homeowner chooses—and the sophistication of the completed project—these fully transformed homes can compete effectively with new construction. Even within the same neighborhood, market-relevant homes perform far better than houses with neglected improvements, which were allowed to slide into flipper or teardown status.
Improvement strategies that are properly executed cost far less than new construction and provide multiple advantages. In addition to accessing recent price rises to finance borrowing, homeowners can literally leverage their existing structure value, reducing overall construction costs by limiting required materials. The updates enhance property values, and through intelligent planning can increase tax write-offs and limit property tax increases, while greatly improving quality of life considerations.
Assessing Feasibility for Purchase
Here’s an excellent example of how MasterWerks gauges, leverages, and engineers structure value on behalf of our clients—in this case beginning with the savvy purchase of a 1970s home, which we advised. Desirably located on Minnehaha Creek, the original brick house went largely untouched over its lifespan and was a candidate for total interior transformation. The new owners acquired the property for $950,000—a price below average site value (see chart). Doing the math, that meant they essentially paid nothing for the existing,
reusable structure which had extensive potential.
Our clients invested in a complete rebuild, including restructured floor plan, new mechanicals, bathrooms, kitchen, mudroom, and other requisite features, for a finished total of 6,100 square feet. The actual building cost of this complete transformation was $164 per square foot versus the average $350 charged by local builders for comparable new construction.
Homes that Lose Market-Relevance Are Targets for Sharp-Eyed Investors
As properties decline in value due to physical, economic, and functional obsolescence, they lose market-relevance. That loss of relevance creates opportunities for investors or savvy potential owners, interested in buying properties at below-market prices and renovating the structure if the upside warrants reinvestment or promises economic payback. (If the structure is too far gone, it typically becomes a teardown.) These rehabs give homeowners a way to move into desirable neighborhoods at considerably lower cost than new construction options.
The lesson is clear: Failing to maintain your home’s market-relevance will cost you money when the time comes to sell. Alternatively, if you invest in your home wisely, over time, you can improve your standard of living and still reap the rewards when your house goes on the market.
Generate Green Benefits in Every Sense of the Word
Along with financial benefits, thoughtful remodeling strategies yield a more sustainable lifestyle. By upgrading insulation and installing energy-efficient windows, HVAC systems, LED lighting, EV charging capabilities, water-conserving fixtures, and other components, you reduce monthly expenses and enhance comfort, flow, and functionality. By limiting demolition and recycling materials, you leverage your existing structure and reduce construction debris sent to landfills. Simultaneously, you help preserve your neighborhood’s character with a lighter energy footprint.
Together, these choices enhance the value of your home while contributing to lower-cost ownership and lessening strain on environmental resources. However, not all improvements or remodeling create value and green benefits. Poorly done, they can, in fact, impair value and require costly rework.
That’s why it’s important to find partners who know and understand what works and what doesn’t. While MasterWerks doesn’t claim to predict the future, we do have a proven track record of helping clients prepare for it, by providing proper guidance first and building second. The right improvements, intelligently calibrated, can improve your living conditions, enhance equity and sustainability, and position you for anticipated or unanticipated resales.
Please note: Material and information contained in this Perspective are deemed reliable but intended only for general information purposes.
The presented data and recommendations must be independently verified prior to exclusive reliance thereon.
Note the difference in potential gains, illustrated by the four renovations versus the two neglected teardowns, which must be replaced by expensive new construction.
INFORMED OBSERVATIONS ON CURRENT HOUSING CHALLENGES AND OPPORTUNITIES
