Although interest rates remain near record lows, it is important not to lose sight of how these low interest rates impact home prices, especially when inflation threatens rate hikes earlier than expected.
In recent months, the Consumer Price Index (CPI), one of the main measures of interest, has been above the Fed’s target rate of 2% year-on-year inflation (most recently around 5%). While some signs indicate that this inflation is temporary, it is something to watch out for. Rising inflation has broad implications for both property prices and property investors.
When inflation rises, the government generally wants to stop it. The government’s main tool for fighting inflation is high interest rates, which work by reducing the money supply in the economy. And while this tactic tends to work to control inflation, rising interest rates can slow down or even reserve gains in property prices.
How Interest Rates Impact Affordability
First, interest rates affect the affordability of mortgages.
When interest rates are low, it is less expensive for people to borrow money. 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 life of the loan. This is good in general! Nobody wants to pay a lender or bank a penny more than they owe (sorry, lenders).
But the savings borrowers enjoy from low interest rates can also increase property values because low interest rates increase home affordability. When borrowers pay the bank less, 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 keep her mortgage principal and interest (P&I) payments around $ 1,900 per month.
A few years ago, when interest rates averaged around 5%, Julia would have peaked on a property that cost around $ 425,000. For that price, Julia would deposit $ 85,000 (assuming a 20% down payment), and the P&I of her mortgage of $ 340,000 ($ 425,000 – $ 85,000) would come out to $ 1,825.
But now, mortgages are around 3%, which means Julia can afford a $ 550,000 house. A down payment would cost you $ 110,000, and although your loan would now be $ 440,000 ($ 550,000 – $ 110,000), your payments would be $ 1,855.
Payment of a loan of $ 440,000 at 3% = $ 1,855
Payment of a loan of $ 340,000 at 5% = $ 1,825
Just because interest rates dropped from 5% to 3%, Julia can now afford a property that is $ 125,000 more expensive than the property she could afford a few years ago! That is a big difference in the price range.
Take a deep dive into investing
Want more in-depth analysis like this one from Dave? A successful investment requires accurate and easy-to-understand information about your properties and the markets in which you invest. BiggerPockets Pro gives you the information you need to find your next great deal and maximize your current investments.
Does affordability affect the housing market?
Increasing affordability does not necessarily drive housing on its own. Still, when you combine increased affordability with the historically low home inventory we’re currently seeing, it’s a perfect setting for prices to go up.
People want houses and there is not much to buy. Rather than pocket the savings from low interest rates, many borrowers who intend to buy choose to use the money they are saving in interest to increase the price of the house. Hence all the bidding wars.
Going back to our previous example, if Julia were looking for a house that cost $ 450,000, we know from our previous calculations that she can afford a house up to $ 550,000, so she can increase the cost of that house from $ 450,000 to $ 550,000. and still stay within your budget.
Think about that for a second. Interest rates that drop from 5% to 3% mean that a single person can increase the price of a home by $ 100,000 (22%!) Without changing their budget.
Of course, this is just an extreme example. But taken together, this increased affordability can, and often does, drive up prices across the housing market.
Conversely, if interest rates rise and affordability falls, it has the potential to slow or even reverse gains in property prices. It doesn’t always happen that way, but the affordability of mortgages can significantly affect real estate.
How Interest Rates Affect Risk Assessment
In addition to affordability, there is a more mathematical way that interest rates affect home prices that is particularly relevant to real estate investors.
Most investors choose to value real estate for the income that the property generates, as it allows them to measure the return on investment. Typically, a metric known as the capitalization rate is used for this exercise.
The capitalization rate is easy to calculate. You simply divide the net operating income (NOI) of a property by the market value of the property. For example, if you have a NOI of $ 50,000 and a property worth $ 1,000,000, the maximum rate is 5%.
When trying to calculate the value of a property, you can use the inverse of this formula. Simply divide the NOI by the average capitalization rate in your area.
For example, if you toured a property with $ 30,000 in NOI and the cap rate for similar properties is 7%, you probably want to pay around $ 429,000 ($ 30,000 / .07).
Sellers generally like a low capitalization rate and buyers like the opposite: they want to buy at a higher capitalization rate.
However, the capitalization rate in your area is fluid. No one sits down and sets what the ceiling will be for multi-family properties in Atlanta. Instead, it is a product of the free market.
Sometimes a bullish investor may be willing to buy at a relatively low capitalization rate of 3-4%. Other times, investors may demand a capitalization rate of 10% or more for their investment. It all depends on the risk / reward profile of a particular investment and the macroeconomic climate.
Right now, compounding rates tend to be low. With low interest rates, investors have lower expenses because they are paying less to their lenders. With lower expenses, the risk is reduced. This (combined with several other economic factors that we won’t look at here) can encourage investors to buy at a lower capitalization rate.
But, when interest rates start to rise, compounding rates generally follow. As an investor, when interest rates go up, your expenses go up. With increasing expenses, risk increases. And with more risk, investors must demand better prospects for return in the form of higher capitalization rates.
But here’s the catch: Higher capitalization rates lower the property’s value. This should be evident from the formulas we reviewed earlier.
Remember that property with $ 30,000 in NOI we were considering? At a 7% capitalization rate, the property was estimated to be worth $ 429,000 ($ 30,000 / .07). But, at an 8% capitalization rate, that same property is worth about $ 375,000 ($ 30,000 / .08). When investors demand higher capitalization rates (often due to rising interest rates), they lower property values.
This is not necessarily good or bad. Owners and sellers could see a decrease or even a reversal in price appreciation, which is never fun. But on the other hand, many buyers will likely accept lower property values even if financing is more expensive. Either way, it is an important dynamic to monitor for the next several months.
While fluctuations in interest rates have the potential to affect property prices, it is not yet clear what will happen in today’s market.
When rates change gradually, it does not always correspond to a big change in market dynamics.
Interest rates rose between 2016 and 2019, for example, and property prices rose steadily during that time. Therefore, if interest rates start to rise, it will not necessarily cause a drop in prices or any kind of collapse.
My best guess is that rates will start to rise in the coming months, but it will happen gradually. This should lead to the housing market cooling to normal growth rates (think 4-8% YoY growth instead of 22%), but we won’t see a reversal in property prices, at least in the next few years. year or so.
For me, it would take a rapid rise in interest rates with a corresponding fall in demand or a huge excess inventory for prices to reverse, and I personally don’t see that happening anytime soon.