Interest Rates 101
Interest rates are an absolute critical component in any real estate investment opportunity. They have a significant impact on the value of income a property could produce which impacts the present value of future cash flows. There are financial institution interest rates, i.e. banks or lenders, and government based interest rates which are influenced by the Federal reserve.
Why do interest rates rise?
There are many factors that contribute to the rise in interest rates. At a basic level, interest rate hikes occur due to sustained Gross Domestic Product (GPD) growth, improved consumer confidence, healthy employment creation forecasts, and employment reaching capacity levels. Other important factors that change interest rates are inflation, bond supply, bond demand, and the federal reserve. Inflation is the substantial rise in general prices which is directly related to a rise in volume of money that results in loss of value of currency. Please see the article titled, “Benefits of Investing in Real Estate” for more information regarding inflation. When inflation rates rise, interest rates rise to compensate for any anticipated loss. Similarly, with an increased supply in bonds, interest rates will increase due to lenders being forced to borrow at a higher interest rate depending on the rates of supply and demand. When there is a decrease in bond demand, higher interest rates will occur due to lenders offering a high return to gain more capital. Lastly, the federal reserve has the power to raise or lower interest rates. The Federal Reserve tends to raise interest rates when there is a significant increase in inflation or when unemployment drops lower than the normal rate.
What Does This Mean for Real Estate Values?
As interest rates rise, the more expensive it becomes to borrow money to invest. Thus, the value of any future cash flow from a real estate investment decreases with raised interest rates. This lowers the value of the asset, resulting in a lower return. As a result, higher interest rates cause investors to seek higher returns which makes any property less attractive because the return is ultimately unchanged.
How Does This Impact Investors Today?
The 2008 financial crisis fueled the Federal Reserve’s quantitative easing program consisting of more than $2 trillion dollars, with a purchase of over $3 trillion in assets. This strategic move has kept inflation at a normal rate. Today, our recovering economy continues to show signs of stability, which means now is an excellent time to invest. Cityvest can help you weigh the possibility of rising interest rates in choosing the type of real estate investment you intend to pursue. Contact Cityvest today!