While interest rates remain near historic lows, it’s important not to lose sight of the impact these low rates have on house prices – especially as inflation threatens to hike rates sooner than expected.
In the last few months, the consumer price index (CPI), one of the most important metrics, has exceeded the Fed’s inflation target of 2% year-on-year (most recently around 5%). While some evidence suggests this inflation is temporary, it is something to monitor. Rising inflation has far-reaching effects on both property prices and property investors.
When inflation rises, the government usually wants to stop it. The government’s primary tool in combating inflation is increased interest rates, which work by reducing the amount of money in the economy. And while these tactics tend to work for fighting inflation, rising interest rates can slow, or perhaps even hold back, the rise in house prices.
How Interest Affects Affordability
Primarily, interest rates affect the affordability of mortgages.
When interest rates are low, people will find it cheaper to borrow. Interest rates are essentially a measure of how much a borrower pays a lender to borrow money. The lower the interest rate, the less the borrower will pay the lender over the course of the loan. That is basically good! Nobody wants to pay a lender or bank a cent more than they have to (sorry, lender).
But the savings borrowers enjoy from low interest rates can also drive up property value, as low interest rates make housing more affordable. When borrowers pay less to the bank, they can afford more expensive homes.
Let’s look at an example.
Julia has a budget of $ 120,000 for a down payment and wants to limit the principal and interest (P&I) payments on her mortgage to about $ 1,900 per month.
A few years ago, when interest rates averaged around 5%, Julia would have hit the max on a property costing around $ 425,000. For that price, Julia would set aside $ 85,000 (assuming a 20% down payment), and the P&I of her $ 340,000 mortgage ($ 425,000- $ 85,000) would be $ 1,825.
But now the mortgages are hovering around 3%, which means Julia can afford a $ 550,000 home. A down payment would cost her $ 110,000, and while her loan would now be $ 440,000 ($ 550,000-110,000), her payments would be $ 1,855.
Paying a loan of $ 440,000 at 3% = $ 1,855
Paying a loan of $ 340,000 at 5% = $ 1,825
Just because interest rates have dropped from 5% to 3%, Julia can now afford a property that is $ 125,000 more than the property she could afford a few years ago! That’s a huge difference in the price range.
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Does Affordability Affect the Housing Market?
Rising affordability is not necessarily the only driving force behind residential construction. However, when you combine the increased affordability with the historically low housing stock we are currently seeing, this is a perfect scenario for prices to rise.
People want houses and there isn’t much to buy. Rather than pocket the savings from the low interest rates, many borrowers considering a purchase choose to use the money they save on interest to increase the price of the home. Hence all bidding battles.
Going back to our previous example, if Julia looks at a house for $ 450,000, we know from our calculations above that she can afford a house up to $ 550,000 – so she can cut the cost of that house from $ 450,000. Increase dollars to $ 550,000 and still stay within your budget.
Think about it for a second. The interest rates, which drop from 5% to 3%, mean that a single person can add $ 100,000 (22%!) To the price of a home without changing their budget.
Of course, this is just an extreme example. But overall, this increased affordability can – and often does – drive up prices across the housing market.
Conversely, if interest rates rise and affordability falls, this can have the potential to slow or even reverse the rise in property prices. This is not always the case, but mortgage affordability can have a significant impact on property properties.
How Interest Rates Affect Risk Assessment
In addition to affordability, there is a more mathematical way how interest rates affect property prices that is particularly relevant to property investors.
Most investors choose to value real estate based on the income that the property generates as it allows investors to measure their return on investment. Typically, a metric called the cap rate is used for this exercise.
The cap rate is easy to calculate. You simply divide a property’s net operating income (NOI) by the property’s market value. For example, if you have a NOI of $ 50,000 and a property worth $ 1,000,000, the cap is 5%.
When trying to determine the value of a property, you can use the reverse of this formula. Simply divide the NOI by the average cap rate in your area.
For example, if you’ve viewed a property with a NOI of $ 30,000 and the similar property cap is 7%, you will likely want to pay around $ 429,000 ($ 30,000 / 0.07).
In general, sellers like a low capitalization rate and buyers like the opposite – they want to buy at a higher capitalization rate.
However, the upper limit in your region is fluid. Nobody sits down and decides what the upper limit on apartment buildings will be in Atlanta. Instead, it is a free market product.
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Sometimes a bullish investor is willing to buy at a relatively low cap rate of 3 to 4%. In other cases, investors can ask for an upper limit of 10% or more on their investment. It all depends on the risk / reward profile of a particular investment and the macroeconomic climate.
Cap rates are currently tending to be low. When interest rates are low, investors spend less because they pay less to their lenders. With less spending, there is less risk. This (when combined with various other economic factors that we won’t go into here) can encourage investors to buy at a lower capitalization rate.
But when interest rates start to rise, cap rates usually follow. When interest rates go up for you as an investor, it means your expenses go up. As spending increases, so does the risk. And with a higher risk, investors have to demand better return prospects in the form of higher cap rates.
But here’s the catch: higher caps lower property value. This should be evident from the formulas discussed above.
Do you remember the $ 30,000 property in NOI that we were considering? With a 7% cap, the property was valued at $ 429,000 ($ 30,000 / 0.07). But with an 8% cap, the same property is worth about $ 375,000 ($ 30,000 / 0.08). When investors demand higher cap rates (often due to rising interest rates), they reduce the property’s value.
It’s not necessarily a good or a bad thing. Owners and sellers may see a decrease or even a reversal in price increases, which is never fun. On the flip side, many buyers are likely to welcome lower property values even if the financing is more expensive. In any case, it is an important dynamic that needs to be monitored over the coming months.
While interest rate fluctuations have the potential to affect house prices, it is still unclear what will happen in today’s market.
When interest rates change gradually, it does not always correspond to a large shift in market dynamics.
For example, interest rates rose from 2016 to 2019, and house prices rose steadily during that time. So if interest rates go up, it won’t necessarily lead to falling prices or some kind of crash.
My best guess is that interest rates will rise over the coming months, but it will be gradual. This should allow the property market to cool down to normal growth rates (think 4-8% YoY instead of 22%), but we won’t see a turnaround in property prices for at least the next year or so.
For me, it would take a rapid rise in interest rates with a corresponding fall in demand or a huge flood of inventory for prices to reverse, and I personally don’t see that happen anytime soon.