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The Effects of Rising Interest Rates on Real Estate

07/30/2014
Fundrise blog, crowdfunding blog, CRE blog, RE investing blog

Today’s blog is a slight departure from our previous posts on the ins and outs of real estate crowdfunding, but an important topic nonetheless.

As we expand access to real estate investment to investors who’ve never been able to invest before, we get a lot of questions on the basics of real estate finance and how to evaluate investments.

While there are some useful resources exist (see our post on the top 89 blogs to follow), we’ve come to realize that there’s a need for more easy-to-understand educational real estate content.

Today I’m going to address a topic that we’re frequently asked about - how interest rates impact real estate.

Interest rates are critical to the performance of any investment because of their impact on the present value of future cash flows. The unprecedented actions taken by the Federal Reserve as a result of the 2008 financial crisis produced a quantitative easing program on a scale never before seen — more than $2 trillion dollars. As a result, it’s never been more important for investors to understand the impact that rising interest rates can have on their portfolios.

What causes interest rates to rise?

Experts point to four key drivers of changing interest rates: inflation, bond supply, bond demand, and the Federal Reserve. As inflation expectations rise, consumers believe they will lose purchasing power in the future and their money will be worth less. Interest rates increase to compensate for the perceived loss.

Increased supply in the bond markets can also lead to higher rates as issuers are forced to borrow at higher interest rates based on supply and demand dynamics. A decrease in bond demand will lead to higher rates, as issuers offer investors higher returns in order to raise capital.

The Fed attempts to manipulate these drivers by buying and selling assets, effectively controlling the market. Although the Fed has the intention of suppressing rates by buying bonds (oversupply the market with capital), this action can also raise inflation expectations, potentially offsetting any impact on actual interest rates.

How does this impact real estate values?

When changes in interest rates are viewed as an independent variable (that is, they change while everything else remains constant), their effect on real estate is clear. At the end of the day, the value of any investment is the sum of the future cash flows from that investment, discounted back to present value. As interest rates rise, the value of any future cash flow decreases, which lowers the value of the real estate property. Higher interest rates cause investors to demand higher returns, which makes any property less appealing given that the return on the specific investment remains unchanged.

However, interest rates never change alone, so it’s useless to analyze the potential effects on real estate value without thinking about the other factors that may occur in tandem with changing rates.

Inflation is often the critical driver of interest rates, and the two typically move together. While rising interest rates can reduce the value of future cash-flows, inflation can increase the value of physical property due to the fact that real estate is a hard asset (see our related post, “Real Estate is a Hard Asset”). If the increase in property value from inflation outweighs the decrease caused by rising rates, the net result can be positive. This fact has made real estate one of the most sought after investment classes in periods of rising rates because of its ability to weather the storm of inflation.

Why does this matter to investors today?

The Fed’s quantitative easing program has resulted in the unprecedented purchase of over $3 trillion in assets. While certainly up for debate, the goal of the QE program is to stabilize prices for these assets, maintaining demand in the marketplace and effectively lowering their yield.

Surprising to many, there has been little to no inflation as a result from the vast sum of money the Fed has injected into the economy. Some attribute this lack of inflation to bank hesitancy about lending, effectively keeping capital supply artificially low. However, with the economy continuing to show signs of a stable recovery, many believe that banks will increase their levels of lending, which would flood the market and quickly drive up inflation. This, in combination with the Fed slowing its asset purchases, could lead to a significant increase in interest rates.

The possibility of rising interests rates is an important factor to consider in any investment decision. Fixed-income investments are a necessary part of a diversified portfolio, but most fail to offer the same protection against inflation that real estate does. With the increasing possibility of rates rising substantially in the near future, most experts agree that real estate is a particularly attractive investment in today’s market.

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By: Ben Miller

Co-Founder | Fundrise

Twitter: https://twitter.com/BenMillerise

Visit Ben's Website: www.fundrise.com

Email: contact@fundrise.com

Visit Ben's blog: blog.fundrise.com

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