Interest Rates Will Affect the Real Estate Market: Yes or No

[Joe Splitrock]

I have heard many different opinions on the subject. Some people strongly believe that higher interest rates will have no effect on housing sales or prices. Others believe it will drive down demand and cause prices to flatten or drop. Some even predict a crash, which I don't think makes sense. Here are my thoughts, but I am interested in what all of you think.

- The reason the Fed is taking action to drive up interest rates is to cool down the economy. This point alone indicates that (at least the Fed) believes higher interest rates will slow down inflation and cool off the housing market.

- Demand is demand. If someone wants to buy a rental property and it makes sense at 4% or 5%, it will not deter someone from buying at the higher rate. Of course more cash flow is better, but people were already buying based on future expected cash flow. Of course higher rates mean higher payments, so at some point it affects the math too much to ignore. At that point it would put pressure on the sales price or pressure on rents.

- Most people refinance investment properties over time, so even if you were lucky enough to lock into a sub-3% rate, you will probably end up refinancing out of it. If you are stuck in a 5.5% rate, odds are good you will be able to refinance into the 4% within the next couple years. That means in many cases your acquisition rate is really temporary.

- There is a psychological effect that can't be underestimated. I see posts (here or on Facebook) every day from investors who are shocked to be quoted 5% or higher on an investment property, when they expected something in the 3's. Some people even say, "I am not paying that much interest". It seems there is a point where investors will say pass. Is that 5.5% or 6% or 7%? 

- Speaking strictly of owner occupied housing, interest rates probably matter less. First of all, they pay a lower rate than investors. Secondly, they are comparing their payment to what it would cost to rent. Maybe one effect of higher rates is it opens opportunity for owner occupied buyers to start winning more deals.

- There are barriers to how high rates are likely to go. As rates climb, it can reduce the number of loans written. At the same time, higher rates make the underlying investment better. Whether that loan is bundled into a mortgage backed security or held by a bank, higher rates will open new interest. Instead of relying on the Fed to artificially stimulate demand and hold prices down, the lending market will find it's own equilibrium. 

Inflation is actually it's own market equalizer. If gas doubles in price, people reconsider long road trips. They buy fuel efficient cars. They take steps to reduce consumption. Increasing the cost of lending could actually fuel inflation in the end. If a business is trying to expand capacity and needs a loan, they will pay more money. That cost is passed to end consumers. If an investor has added interest expense, they will pass that along to the renter. When you think about it, both inflation and increased interest rates will mostly only reduce discretionary spending. People will reconsider taking that vacations or buying a boat. Food, rent and even gas are necessary expenses for most everyone. 

Share your thoughts!