We’ve explored the many factors that affect property values. This includes everything from the balance between supply and demand, to more specific property traits and so on. For now, we’re going to focus specifically on how interest rates affect a property’s profit potential.
First, let’s consider how interest rates are used in monetary policy.
Before we explore how interest rates affect a property’s return, we should first understand how interest rate fluctuations are used in the broader economy under monetary policy. Essentially, the central bank of a country conducts monetary policy and controls the spending of an economy by adjusting interest rates. As economies experience rapid and prolonged growth, the central bank tends to step in. By doing so, the central bank is helping to protect the economy from over-inflation. By raising interest rates in an expanding economy, it becomes more appealing for consumers to save their money. This way, you can yield higher returns by saving your money. In the opposite case, interest rates are generally lowered to help spur spending in recession-like economies.
Now that you understand how interest rates are used as an economic tool, let’s talk about how they can affect a property’s profit potential.
How do interest rates affect the real estate market?
First, let’s note that interest rates affect both the demand and supply sides of the real estate market. This is intuitive when you consider that interest is charged on debt financing and debt financing is used for both purchasing and building real estate. However, in both cases, higher interest rates tend to imply less spending, or at least more expensive financing options.
From an investor’s perspective whose looking to purchase a property already on the market, interest rates will definitely affect whether a potential opportunity appears to be lucrative or not. If debt is used to finance these activities, higher interest rates tend to eat away at normal returns. As such, lower interest rates are preferred and will tend to lead to greater demand (i.e. higher levels of investment activity).
From a real estate developer’s perspective, interest rates also come into play. Again, this business activity is typically financed through debt instruments so interest rates have a direct impact. The same logic can follow here that lower interest rates tend to spur more investment and development activity.
As you can see, interest rates alone don’t tell the full picture about a property’s true value. However, it does give you a better sense about the property’s value to a particular investor. If this value is measured in terms of the potential investment return, then interest rates as a matter of fact, lower the potential return since you have higher interest expenses.
What happens when you put the two together?
So what happens when we apply the fundamentals from each of the previous two sections? Well, it paints a picture that we may not have guessed at first. So let’s consider the situation of an expanding and prosperous economy. Well in this case, interest rates will likely eventually be raised. When this happens, you may think the potential returns of properties would lower. However, this isn’t always the case. Since the economy is already expanding and higher interest rates are meant to reduce spending, it doesn’t happen immediately. As such, property values in some cases in the past have actually continued rising despite higher interest rates.
The complete opposite can be just as true in the case of a declining economy. Here, property values could be on the decline when interest rates are lowered. Again, this doesn’t have an immediate effect and property values could happen to dwindle further.
The bottom line is that a complex array of factors come into play when determining a property’s profit potential and you simply cannot just look at interest rates alone. Today's market is filled with many opportunities for the savvy investor. Our Elite Legacy Education trainers will introduce you to proven strategies that can help you launch your career as a successful real estate investor.
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Founded in 1992, Elite Legacy Education is a recognized global leader in quality financial education. Legacy Education Alliance, Inc. is a leading provider of educational training seminars, conferences and services. Rich Dad Education offers real estate & stock training based on Robert Kiyosaki's book Rich Dad Poor Dad