With the US Federal Reserve raising interest rates to 1.5% in their December 2017 meeting, investors are watching keenly for knock on effects on the stock and property market.
But how exactly does rising interest rates affect property prices? How should an investor position him or herself so that they don’t get caught flat footed?
Many people assume that the only impact interest rates have on property prices are via the mortgage rate channel.
In other words, higher interest rates (or fed funds rate), higher mortgage rates and therefore higher monthly payments.
This is true. But not the whole story.
Interest rates also affect property prices in other ways, such as capital flows, supply and demand for capital and investors’ required rate of returns.
The past few years of a low-interest rate environment has led to US investors putting money outside of the country where rates and potential returns are higher.
With the fed raising interest rates, some of these funds that were destined for countries outside the US, and funds that are now outside of the US, may get ‘called back’ to the US where there is an opportunity to earn a higher rate of return.
If an investor had multiple buildings in Asia and deem the present moment to be a good time to bring capital back to his or her home country, the US, there will be selling in Asia.
With more supply or properties on sale in Asia, the law of supply and demand will then kick in, resulting in downward pressure on prices.
This of course is theory which usually works well, but not all the time. In this current environment, the increase of saleable property doesn’t seem to be putting downward pressure on prices.
I hazard that this is because of the amount of money that is still in circulation. Investors therefore are still greedily snapping whatever properties there are for sale in the market.
Generally though, when interest rates rise, in the US for example, there will be a flow of capital back to the country, resulting in theoretically lower prices in the countries where capital is being called back.
There are other channels by which rising interest rates affect property prices, such as the relative attractiveness between asset classes and the currency effect (the USD should theoretically be appreciating as people exchange more of their currency for the USD), but that doesn’t focus on property so will not be covered.
One other way a change in interest rates affects property is via a change in investors’ required rate of return.
As interest rates rise, investors, investment committees and fund managers need to weigh the relative attractiveness of the different asset classes, namely equities, bonds, property, infrastructure, private equity, commodities and currencies.
There are up and coming asset classes like crypto currencies and exotic derivatives but those aren’t mainstream (yet).
As interest rates rise, the prices of bonds fall, presenting an investment opportunity for keen fund managers.
At the same time, higher interest rates may signal growth in the economy, which may result in higher equity prices as they price in future growth.
Property as an asset class may have to readjust in comparison to these two mentioned asset classes.
If stocks and bonds present a more compelling investment opportunity, a fund manager may need to depress the purchase price of a property so that it can present similar or greater risk adjusted returns than stocks or bonds.
If most fund managers think this way, a correction in property prices would be required.
When investment managers perform their underwriting, they use a discount rate.
This discount rate is closely tied to the movements of the interest rates of a country.
A higher discount rate would mean that future cash flow streams are worth less today.
An investor looking at an income generating piece of property would then want to put up a lower purchase price in exchange for the right to partake in future cash flows.
In real estate investing, a terminal cap rate is also used.
In a cash flow forecast model, the terminal cap rate is used to determine how much the final year’s income is worth today.
With a higher interest rate, there is likely to be a higher terminal cap rate used by investors.
This reduces the worth of that final year’s income today, and therefore the purchase price the buyer is willing to put up.
The bottom line is that interest rates affect property in many ways.
The best way to stay safe when investing is not to over-leverage oneself, and to ensure one has sufficient liquidity to service higher mortgage payments when they come.