The real estate market is known for its large booms and busts that happen over time. The bust of 2008 still looms in recent memory and many homeowners are just now swimming up from being underwater on their home loans. These booms and busts in the real estate market are not random, however, because they are driven by credit. Many players in the real estate market require credit to develop, build and purchase homes. Changes in the credit markets, or interest rates, can thus increase or decrease the speed of real estate expansion.
Falling Interest Rate Environments
1. Developers have access to more capital for longer amounts of time which means they can target riskier land for development projects.
2. Builders can purchase materials on credit for less money in order to finance their building projects.
3. Home buyers can purchase homes and have smaller monthly payments, which means their income streams can afford to purchase more expensive homes.
4. Existing homeowners refinance their houses at lower rates, which lowers their monthly payments. This leaves them with more discretionary income to spend in the economy.
This cycle is self-reinforcing. New home buyers can afford more expensive housing, justifying real estate price expansion. Also, existing homeowners can refinance their houses at lower rates, creating new spending in the economy.
As interest rates continue to fall, high-priced purchases of newly developed homes cause developers to gain profit and confidence. This leads developers to reach for riskier property in attempts to recreate profits gained from the first development. Builders continue building on credit because of strong economics in the housing market. And buyers chase rising prices in the hopes of continued increases in price while homeowners continue to leverage their homes in the hopes of the same.
And then the cycle reverses as interest rates begin to increase.
Rising Interest Rate Environment
1. Developers find it more difficult to purchase property for development and so hold it for less time due to the increased cost of interest. Some developers go bust because they are unable to find buyers for their expensive new homes, causing other developers to be more selective in their land development projects.
2. Builders become less creditworthy and lenders are less likely to extend building loans because the lenders are less sure of their likelihood to get paid back. This can increase the mortgage interest rate for builders even further which causes building a new home to become more costly.
3. New home buyers find that their income streams are only able to afford lower-cost homes because higher interest rates means higher monthly home payments. This decreases the prices of homes.
4. Existing home buyers who overleveraged their houses now find that their existing loans are worth more than the underlying value of the house. Homeowners who refinanced using fixed rates, when interest rates were low, have lower payments than others who refinanced using variable rates. This is because variable interest mortgage payments increase as rates rise.
Again, this cycle is self-reinforcing. New home buyers cannot afford expensive houses, causing them to not buy a house or only buy lower-priced houses. Overall lower prices in the market means homebuilders find it difficult to find lenders for homebuilding, making building projects more expensive. Developers are only able to acquire smaller loans due to decreased housing prices and the interest costs of these loans increases.
As interest rates continue to rise these trends accelerate. Developers might stop producing new homes all together due to the high cost of holding loans. Homebuilders might find that there is little work because there are fewer houses under construction, causing some homebuilders to go bankrupt. New homebuyers may find themselves priced out of the market because their income streams are not large enough to afford the high monthly payments. Existing homebuyers focus on paying back their home loans instead of refinancing their homes.
But what about investment properties and rents?
Investment in Anything Is Done to Increase Wealth
And real estate is no exception.
In a low interest rate environment property values increase and so does rent. The price of rent is directly related to the value of the property. While there are exceptions such as subsidized housing, this relationship is generally true.
Most investment properties focus on creating income streams by collecting rent. Real Estate Investment Trusts or (REITs) are a prime example of an investment tool that provides investors with income streams created by tenants paying rent.
When interest rates rise, property values fall. While it may take some time for this relationship to play out, eventually a high enough interest rate will price out many buyers, lessening demand and causing overall prices to fall.
As property values fall, rents will also decrease. In addition, rent prices may also be pushed downwards by the loss of demand (income streams or jobs) connected to the falling real estate market.
Because the value of REITs and other real estate investments are connected to the value of their future cash flows, the values of these investment assets will fall as rents fall.
Here are a few large real estate ETFs to watch out for:
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