At a press conference in early June, Fed chairman Jerome H. Powell announced an increase in interest rates for the second time in 2018 and predicted two more increases before the end of the year. These increases, which the Fed is directly linking to increasing optimism about the economy, bring interest rates back to near 2 percent, a benchmark last seen before the economic collapse of 2008.
While increasing interest rates are undeniably beneficial for lenders, the impact on consumers remains decidedly mixed. Although a robust national economy is generally a positive indicator for growth and security, which in turn fuels investment, the interest rate increases will almost certainly translate into higher borrowing costs for auto loans, credit cards, and mortgages for the foreseeable future.
So what do these rising interest rates mean for the economy in general and the real estate property market in particular? Here are five things you should know:
1. THE REAL ESTATE MARKET WILL FLUCTUATE, BUT NOTHING IS CERTAIN
As interest rates rise, changes to the commercial and residential real estate markets are an absolute certainty, but be careful not to assume you know too much about how those changes will impact a specific market. Although decreasing demand for commercial property and higher home mortgage rates are to be expected, be careful to monitor the actual changes in the real estate market based on trustworthy data rather than industry speculation.
2. DECREASED BORROWING POWER FOR MANY AMERICANS DUE TO SLOW WAGE GROWTH
Although the increase in interest rates is a sign of a healthy overall national economy, the reality is not quite as rosy for the shrinking American middle class. According to a 2017 Brookings Institute study, real wages for the vast majority of middle-class workers have only increased 3.5 percent in the past four decades, while salaries for those in the top income bracket jumped 24 percent. Not only is the Wage Gap is real, but the divide is skewering further apart at an alarming rate.
The lack of wage growth, even in a robust economy, creates severe problems for housing markets. Although workers may have job security relative to the nation’s economic prosperity, they still need to be able to afford to pay their mortgages for housing markets to grow. By increasing interest rates, even nominally, monthly mortgage payments will rise with no additional return on investment for homebuyers. When people can’t afford a mortgage, they rent instead of buy, which lowers housing demand and can lead to devaluation of the residential real estate market. Lower wages also limit consumer spending necessary for economic growth.
3. A RAPID RISE IN FORECLOSURES… WHERE HAVE WE HEARD THIS BEFORE?
In his remarks, Fed chair Jerome K. Powell directly linked these 2018 interest rate costs to the 2008 recession. We cannot afford to forget that one the prime underlying causes of that recession were high foreclosure rates on mortgages that had been securitized by investors. When enough of the mortgages (many of which can be politely referred to as extremely sub-prime) became toxic because there was more owed than the property was worth, the rot spread like the Wall Street equivalent of the Bubonic Plague. Housing markets crashed nationwide.
As many of the legislative efforts to prevent history from repeating itself have been repealed, gutted or never enacted in the first place, the onus falls on the financial sector, not the government, to avoid another collapse. Will the lessons of 2008 protect us? Only time will tell.
4. INVESTOR CONFUSION IN COMMERCIAL REAL ESTATE MARKETS
Interest rates have as profound an effect on the value of income-producing real estate as on any other investment vehicle. While it is true that the influence of rates on a person’s ability to buy residential property by raising or lowering the cost of mortgage capital is so significant, many investors assume (incorrectly) that mortgage rates are the only deciding factor in real estate valuation.
Relying solely on mortgage interest rates is a common mistake, but can ultimately be a costly one that separates the amateurs from the professionals. Interest rates also impact capital flows, which means investors’ required rates of return on investment will change as a result of interest rate changes. The valuation for commercial real estate financing is built on a model of projected income from the property minus other expenses (including financing costs), which means those costs can be rolled into the ultimate sale or lease price.
In simple terms, interest rate increases are not necessarily a problem for commercial builders so long as those increased costs are factored in and passed along correctly. But in a period of rising interest rates, there will likely be a period of confusion that could adversely impact those who don’t know how to adjust appropriately.
5. IS INFLATION THE ENEMY? IT DEPENDS.
In real estate markets, the relationship between inflation and rising interest rates is a complicated one. While inflation often drives interest rates and the two are naturally tied together, they are separate metrics with their own nuances. Although rising interest rates can reduce the value of future cash flow from real estate, increased inflation has the unique ability to increase the value of real estate because hard assets become more valuable as inflation increases.
A substantial reason why real estate is so attractive to investors in the wake of interest rate hikes is that of its historical propensity to survive any subsequent rise in inflation. So long as the increase in property value from inflation outweighs the decrease caused by rising rates, the net result is a winning one for investors.
The trend of increasing interest rates signals a definite shift in the U.S. economy in general and real estate markets in particular. Although experts can predict some of the impacts with a reasonably high degree of certainty based on historical performance, there are always unexpected elements and unintended consequences as both individuals and companies respond in various ways. By keeping your eyes and ears open, you can use informed decisions to help you navigate the winds of change.
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