What Happens to Real Estate Prices When Interest Rates Rise?

Published on
 
February 1, 2023
What happens to real estate when interest rates rise

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Prudent real estate investors are always examining the relationship between interest rates and housing prices. 

Interest rates typically have an inverse relationship with home values. Higher interest rates typically lead to depressed housing prices due to the dynamic where buyers have larger monthly payments to afford the same home at the same price.

How do changes in interest rates affect the market for real estate? In this article, we'll examine the correlation between these two variables and how it’s changed over time. Additionally, we’ll explore several smart strategies for investing in real estate amid rising interest rates.

Understanding the Relationship between Interest Rates and Real Estate Investing

Interest rates are one of the most important factors for real estate investors to consider when deciding where and how to invest. When interest rates rise, borrowing money is much more expensive, meaning buyers may be unable or unwilling to make a larger payment for their ideal home. 

This situation can lead to a decrease in demand by pushing out prospective homebuyers, which could lead to a broader decline in housing prices. On the other hand, if interest rates drop significantly, buyers can make smaller monthly payments for the same house, and in the end potentially increasing their profits when the property is refinanced or sold.

Different markets will respond in different ways to changes in interest rates. The response is based on local economic variables such as unemployment levels, the income profile of potential buyers, population growth and decline, rent control, and other influencing factors like property taxes and proximity to amenities or job opportunities. 

For example, some cities may experience drastic drops in home values due to high foreclosure rates or markets where prices had bubbled. Others remain more stable despite fluctuations in mortgage costs because they maintain strong demand among buyers seeking amenities or job opportunities and the pricing of homes are more in line with the affordability of that buyer group.

Source: Pew Research Center

During the Great Recession of 2008, areas hit particularly hard included many parts of California, Florida, and Nevada, which had high rates of home foreclosures. Some of these markets took nearly a decade to recover. 

Other states, like Texas, North Dakota, and Alaska, largely remained stable despite fluctuations in mortgage costs due to strong local economies and growing populations that kept demand for housing high. These areas also benefited from their proximity to amenities or job opportunities where there was still strong economic demand. Texas offered close access to oil and gas production, while Alaska’s position near offshore fishing grounds made it an attractive investment. Ultimately, each area responded differently depending on various factors unique to the local economy.

Investors should pay close attention to current trends and those likely to impact future market conditions. Understanding how shifts in global economics might affect borrowing costs over time can help inform investment decisions and ensure investments remain profitable no matter what happens with interest rates down the line. 

Keeping an eye on market trends can also help investors identify areas with good profit potential, even when borrowing costs are relatively high. These trends can point to locations with strong underlying fundamentals, such as positive population growth or underserved needs among buyers or tenants.

What Typically Happens to Real Estate Values When Interest Rates Increase?

Source: St. Louis Fed

The far-reaching implications of higher interest rates typically has a massive effect on the entire real estate market. 

First and foremost, it can lead to decreased liquidity in the marketplace as fewer people can afford mortgages with high borrowing costs. This situation may lead to fewer buyers and less demand for properties in certain areas, resulting in lower prices across the board. 

Higher interest rates can also lead to a lower rate of originating new loans. Lenders become more risk-averse when lending money, leading to tighter loan terms such as higher down payments (we see this in commercial real estate more often than residential) or increased closing costs.

The challenge with a long period where rates remain elevated is that it may impact the psychology of the buyer and seller pool in the real estate market. Real estate is a slower moving asset class, where redefining a market balance can take a while. It generally lags the publicly traded stock market and other areas of the capital markets. This can have a compounding effect of a lower perceived value of real estate in both residential and commercial.

How Different Asset Classes React to Interest Rate Changes

Real estate asset classes can be divided into commercial properties such as office, retail, and industrial spaces; large multi-family apartment buildings; and residential properties such as single-family rental (SFR) homes. Each asset class can react differently when interest rates increase, so it’s essential to understand how each is affected.

Investing in commercial real estate can be tricky when interest rates are rising. If we look at office or retail, one of the main drawbacks is that tenants are often tied to long-term leases, making it difficult to raise rents to cover increasing operating and financing costs especially when they’re contractually put in place. 

In addition, loans for commercial properties usually have short repayment periods of that can be as short as 5 years and generally can go up to 20. This often forces business owners to refinance their loans, which may be a higher rate, or sell in a depressed market if financing cannot be found. This can put stress on those who rely on these investments as part of their income and long-term planning strategy.

By comparison, residential rental property may offer investors more flexibility in increasing their income during periods of rising interest rates due to their shorter lease terms. 

With housing affordability drastically declining, more individuals are seeking rentals and apartments to call home. Since leases typically renew annually, landlords have the ability to adjust rent prices based on market conditions, allowing them to capture higher returns when the cost of capital increases.

Furthermore, compared with commercial properties, which may take a year or longer to sell during even the best of times, residential properties tend to be easier to sell. Therefore, they provide greater flexibility for investors looking for increased liquidity. It’s challenging to compare these exactly, as even within each sub-asset class of real estate there are unique risks that must be managed against, but in general, the buyer and selling pool of residential real estate is much larger than the pool for commercial real estate.

Investing Strategies with Rising Interest Rates

As interest rates rise, investors must remain vigilant to pay attention to all the changes. There are ways to take advantage of the rising rate environment. Let’s take a look at a few that we’re seeing today:

Focusing on Near-Term Cash Flow with Long-Term Equity Growth

When interest rates are high, investors should focus on free cash flow instead of equity growth. Cash flow is the difference between the income generated from a given property and the operating costs incurred by homeowners minus any debt that is owed on the property. 

When making new investments in properties focused on generating rental incomes, investors should prioritize positive cash-flow. This gives investors the ability to generate income to offset the potential valuation fluctuations while you wait to sell or to find the right time to get the long-term financing on the asset. 

Finding distressed investment opportunities in real estate

When interest rates rise, there may be opportunities to invest in properties where the sellers are distressed. These look like sellers who have overleveraged themselves or are having a hard time selling their existing portfolio. These sellers may have valued their portfolio at yesterday’s prices with loans that expire in the near future, creating a dynamic where it might make more sense to try to sell what they have than pay to get a loan to keep that property. This can come in the form of construction companies having excess inventory, fix & flippers that started their projects at the peak of the market, or even challenged homebuyers.

Investing in Real Estate Debt

Take advantage of rising rates like the banks do. Another strategy real estate investors can utilize during periods of high interest rates is investing in the debt side of real estate, such as mortgages and private loans.

As a lender, when borrowing rates going up that can easily translate to higher potential return for these investments. Another advantage is their completely passive nature compared to directly investing in real estate while typically being overcollateralized (meaning your money is backed by assets that are worth more). 

Concluding thoughts

A rising rate environment is always a challenging one for investors. There are historical trends that can be observed, but each new cycle brings unique challenges to consider. In today’s environment (as of this writing in early 2023), we have unprecedented inflation, rising interest rates, bubbled asset values and a shaky economy. There’s no silver bullet in this situation and unfortunately investing on trends won’t cut it anymore. As the cycle continues to unfold, it’ll be important to find emerging opportunities as we will see large shifts in the capital markets, broad and local economics and technology will continue to change how we work.

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Disclaimer

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security which can only be made through official documents such as a private placement memorandum or a prospectus. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Neither Concreit nor any of its affiliates provides tax advice or investment recommendations and do not represent in any manner that the outcomes described herein or on the Site will result in any particular investment or tax consequence.Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Concreit does not guarantee its accuracy.

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