Interest rates influence on price of real estate

On January 21, 2013 by Phil Champagne

By Phil Champagne, Managing Partner at Wren Investment Group

Remember the carnage that rising rates have done in the housing sector last time interest rates went down and finally up, we are experiencing the same situation again across many investment vehicles.

With artificially low interest rates set by the Federal Reserve, it allows for cheap borrowing permitting higher purchase price. Once the music stop, that is, when the interest rates jack up again, those who need to refinance or sell will be left without a chair. We covered this in prior article in here and here. However, I came across this article in Bloomberg reporting how this is creating a bubble in multifamily sector, just as we wanted to illustrate before. I recommend you read this article. We are very aware of this and illustrate some of the reasoning for our acquisition guidelines.

Of particular interest is this part in the Bloomberg’s article:

Getting a new, pricier loan for an apartment property bought at today’s prices would require an income increase “stronger than what we think of as a sustainable level of rent growth,” Chandan said in an interview. “Are we making loans today that we are not able to easily finance when they mature? The finding is yes.”

When these rates go up, we expect investors in the construction side to face some hard choices as they usually require short term financing during the construction phase and go with long term financing only once construction complete. If this reset happens before the long term financing, it will be a difficult time.

When rates will go higher, new buyers will require a much higher income to compensate for this higher financing cost, this is illustrating clearly why the 10 year treasury interest rates are influencing the overall market. We are convinced the Treasury bond market is in a 30 years old bull market that is currently the mother of all bubble.

Federal Funds Rate (effective)

Federal Funds Rate (effective) (Photo credit: Wikipedia)

Sure, Ben Bernanke at the Federal Reserve stated they intend to keep interest rates at near 0% until mid 2014 and later said until unemployment goes below 6.5%. But as much as central planners would like, they cannot control everything and the market will eventually decide when it has enough of low interest rate. With effective negative real interest rate, how long before they get enough and jump ship out of the Treasury bonds they currently hold. Right now, the fed is buying near 90% of the US deficit with printed money. To keep interest rates low so the funding of the federal government (who doesn’t want to shrink) stays artificially cheap, the Fed will need to keep this buying going and when the bond holders are jumping ship, they will have to step in to prevent rates to jump up… at the cost of more monetary inflation. The rates nevertheless will go up and so will inflation.
In case you were wondering what this chart has been doing since December 2008, here is one that includes up to end of 2012:

fredgraph

Looking at those 2 charts, we see the trend has been going down for the past 30 years and has reached bottom. The only argument left is when will the rate go back up. Sure they could go negative in which case a lender loses money, more like a storage fee when storing your gold. Indeed, the real interest rate when you account for price inflation is effectively negative, no wonder gold is going up. When gold will start climbing above $2000/oz, this means the preference by the market will be over gold rather than financial instrument with negative real interest rate. This will accelerate the printing by the fed and therefore increase price inflation hence real interest rate going more in the negative. For those who are not familiar with real estate rates, it is the effective rate when you substract price inflation. If your money is at 1% in a savings account and price inflation is at 2%, real interest rate is -1%. But don’t imagine price inflation is at the stated 2% the CPI index is telling us. If it was measured as it was back in the 1970s, it would be above 6%. Any returns currently lower than 6% are effectively negative.

Does that all means it is not the right time to buy real estate? Certainly not. The interest rates are low and the need for real estate will always be kept – as long as you buy the right type of property in an appropriate location. But one must be aware of the disruption in the market that will come at some point in the near future… when the music stops.

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