- Higher interest rates will put pressure on Real Estate buyers by making mortgages more expensive.
- How much more expensive will a mortgage be?
- How did Real Estate prices fair with previous regimes of higher interest rates.
Home owners, buyers and Real Estate [6] investors all have reason to be concerned about the recent interest rate hike by the Fed. We have now begun the transition to higher interest rates with the Fed’s move to raise the Fed Fund rate by ¼%. That’s not that much of a move, but it has doubled the previous rate and above all it means the process that will bring as back to higher interest rates has now begun.
Why would the Real Estate market take a hit?
The fear now is that higher interest rates will stifle the property market. Well that is indeed a risk, which also means it might not happen. It would certainly be the case if interest rates rise faster than the market can assimilate. If the Fed keeps raising interest rates and the economy cannot keep up at the same pace then we could see a large slowdown in the demand for houses from individuals and institutions.
This is easy to conceive as peoples salaries are not rising fast enough and not enough new jobs are being created then there will be less demand for residential property. People will also have less money as they will be paying higher interest on other items often bought with a loan like autos. From the point of view of commercial property if the public is not spending as much in stores and entertainment then this type of real estate also loses value.
Increases in interest rates also make mortgages more expensive. This means that a property becomes less affordable even though the price may remain the same. This will happen for residential and commercial property alike. Ultimately if interest rates rise faster than the economy, prices will probably begin to fall. If the market feels that interest rates are rising too quickly it would probably cause prices in those REITs [7] you own to fall faster too.
Having said all that if the economy does well and expands at a sufficient rate it will be able to accommodate restrictive monetary policy, that is higher rates. In this scenario we should also see inflation begin to rise as the economy is heating up. Real estate is known for being positively linked to inflation [8], so prices could even get a boost in this case.
So how much does a mortgage change?
Those who have a fixed rate mortgage have nothing to worry about, of course. But for the many that have a variable rate mortgage higher interest rates are going to be of concern. There are many mortgage calculators on-line, I particularly like this one, mortgagecalculator [9], as it allows you to contemplate taxes in your monthly payment.
You can see that on a $250,000 mortgage a ¼% rise in the interest rate will only change your monthly payment by $33.14. But considering the loan still has 20 years to go, the overall change in cost during its lifetime is an increase of 3.18% or $7.952. A 1% rise means an extra cost of $32,385, or 12.95% of a $250,000 mortgage with 20 years to maturity.
How have Real Estate prices faired in the past?
The next couple of years won’t be the first period of rising interest rates. In the recent past we’ve seen this happen various times. During some of these periods property values continued to rise. For example, the two periods from 1993 to 1995 and 1998 to 2000, we saw interest rates increase. In both periods returns for real estate still remained positive.
The chart above shows how the NCEREIF [10] (which is a nationwide property index) showed positive price increases for both periods. We can also see that in certain periods where interest rates were falling so where prices in the property index. The period that stands out the most goes from 1990 to 1993. As interest rates begin to decline so do property price increases decline. As the fall in rates continues property price changes even become negative.
We are not bound to see prices fall rapidly or even stall for sure. But what will be necessary for the property market to continue its buoyant price levels, is an economy strong enough to adjust to the higher interest rate regime.
If the economy is expanding rapidly it will be absolutely necessary to raise interest rates, and it will be easily absorbed. If the Fed decides however that the transition back to more typical interest rates is to be made despite an economy that is not expanding fast enough, then we might see prices falter.
