September 10th, 2017 7:03 AM by Jackie A. Graves, President
Interest rates, especially the rates on interbank exchanges and Treasury bills, have as profound an effect on the value of
income-producing real estate as on any
investment vehicle. Because the influence of interest rates on an
individual's ability to purchase residential properties (by increasing or
decreasing the cost of mortgage capital) is so profound, many people
incorrectly assume that the only deciding factor in real estate valuation is
the mortgage rate.
However, mortgage rates are only one interest-related factor influencing
property values. Because interest rates also affect capital flows,
the supply and
demand for capital and investors' required rates of return on
investment, interest rates will drive property prices in a variety of ways.
understand how government-influenced interest rates, capital flows, and
financing rates affect property values, you should have a basic understanding
of the income approach to
real estate values. Although real estate values are influenced by the supply
and demand for properties in a given locale and the replacement cost of
developing new properties, the income approach is the most common valuation technique
for investors. The income approach provided by appraisers of commercial
properties and by underwriters and investors of real estate-backed
investments is very similar to the discounted cash flow analysis conducted on equity and bond
simple terms, the valuation starts by forecasting property
income, which takes the form of anticipated lease payments or,
in the case of hotels, anticipated hotel occupancy multiplied by the average
cost per room. Then, by taking all property-level costs, including the
financing cost, the analyst arrives at the net operating income (NOI), or cash flow remaining, after
By subtracting all capital costs, as well as any investment
capital to maintain or repair the property and other non-property-specific expenses
from NOI, the result is the net cash flow (NCF). Because properties don't
usually retain cash or have a stated dividend policy,
NCF equals cash available to investors and is the same as cash from dividends,
which is used for valuing equity or fixed-income investments. By capitalizing
dividends or by discounting the cash
flow stream (including any residual value) for a given investment period, the
property value is determined.
rates can significantly affect the cost of financing and mortgage rates, which
in turn affects property-level costs and thus influences values. However,
supply and demand for capital and competing investments have the greatest
impact on required rates of return (RROR)
and investment values. As the Federal Reserve Board has moved focus away from monetary policy and more toward managing interest
rates as a way to stimulate the economy or stave off inflation, its policy has
had a direct effect on the value of all investments.
interbank exchange rates decrease,
the cost of funds is
reduced, and funds flow into the system; conversely, when rates rise, the
availability of funds decreases. As for real estate, the changes in interbank
lending rates either add or reduce the amount of capital available for
investment. The amount of capital and the cost of capital affect
demand but also supply, capital available for real estate purchases and
development. For example, when capital availability is tight, capital providers
tend to lend less as a percentage of intrinsic value,
or not as far up the "capital stack." This means that loans are made
at lower loan to value ratios, thus
reducing leveraged cash flows and property values.
changes in capital flows can also have a direct impact on the supply and demand
dynamics for property. The cost of capital and capital availability affect
supply by providing additional capital for property development and also
influence the population of potential purchasers seeking deals. These two
factors work together to determine property values.
most evident impact of interest rates on real estate values can be seen in the
derivation of discount or capitalization rates. The capitalization
rate can be viewed as an investor's required dividend rate, while a discount rate equals an investor's total
return requirements. K usually denotes RROR, while the capitalization rate
equals (K-g), where g is the expected
growth in income or the increase in capital appreciation.
of these rates is influenced by prevailing interest rates because they are
equal to the risk-free rate plus a risk premium. For
most investors, the risk-free rate is the rate on U.S.
Treasuries; these are guaranteed by U.S. government credit, so they
are considered risk-free because the probability of default is
so low. Because higher-risk investments must achieve a commensurably higher
return to compensate for the additional risk borne, when determining discount
rates and capitalization rates, investors add a risk premium to
the risk-free rate to determine the risk-adjusted returns necessary on each
K (discount rate) is equal to the risk-free rate plus a risk premium,
the capitalization rate is equal to the risk-free rate plus a risk premium,
less the anticipated growth (g) in income. Although risk premiums vary as a
result of supply and demand and other risk factors in the market, discount
rates will vary due to changes in the interest rates that make them up. When
the required returns on competing or substitute investments rise, real estate
values fall; conversely when interest rates fall, real estate prices increase.
is important to focus on mortgage rates because they have a direct influence on
real estate prices. If you're a prospective homeowner or real estate investor,
an easy way to research current interest rates is to use a mortgage calculator.
said, it's important to note that changing interest rates affect numerous
aspects of real estate. Beyond the price of your new home, interest rates also
affect the availability of capital and the demand for investment. These capital
flows influence the supply and demand for property and, as a result, they
affect property prices. Also, interest rates also affect returns on substitute
investments, and prices change to stay in line with the inherent risk in real estate investments.
These changes in required rates of return for real estate also vary during
destabilization periods in the credit markets. As investors foresee increased
variability in future rates or increase in risk, risk premiums widen, putting
increased downward pressure on property prices.
By Robert Stammers - To view
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