Interest rates have as profound an effect on the value of income-producing real estate just like they do on any other investment vehicle. This is especially true about the rates on interbank exchanges and Treasury bills (T-Bills). Because their influence on an individual's ability to purchase residential properties (by increasing or decreasing the cost of mortgage capital) is so profound, many people make the incorrect assumption that the only deciding factor in real estate valuation is the current mortgage rate.

But mortgage rates are only one interest-related factor that influences 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 drive property prices in a variety of ways.

Key Takeaways

  • Interest rates can drive property prices in a variety of ways.
  • Similar to the discounted cash flow analysis conducted on equity and bond investments, the income approach takes the net cash flow into account.
  • Interest rates can affect the cost of financing and mortgage rates—changes in capital flows can also have a direct impact on the supply and demand dynamics for a property.
  • The most evident impact of interest rates on real estate values is in the derivation of discount or capitalization rates, as they are equal to the risk-free rate plus a risk premium.

Valuation Fundamentals

Real estate values are generally influenced by the supply and demand for properties as well as the replacement cost of developing new properties. But there's more to valuation than that, especially when you consider how government-influenced interest rates, capital flows, and financing rates affect property values. To understand these dynamics, it's important to have a basic understanding of the income approach—the most common valuation technique for investors. The income approach—provided by commercial property appraisers and by underwriters for real-estate backed investments—is very similar to the discounted cash flow analysis conducted on equity and bond investments.

The valuation starts by forecasting property income, which takes the form of anticipated lease payments or, in the case of hotels, anticipated occupancy multiplied by the average cost per room. After accounting for all property-level costs, the analyst arrives at the net operating income (NOI) or cash flow that remains after all of the operating expenses.

By subtracting any associated capital costs, investment capital to maintain or repair the property, and other non-property-specific expenses from NOI, we end up with the net cash flow (NCF). Because properties don't usually retain cash or have a stated dividend policy, NCF equals cash available to investors—just like 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.

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How Interest Rates Affect Property Values

Capital Flows

Interest rates can significantly affect the cost of financing and mortgage rates, which affects property-level costs and, therefore, 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 the 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.

As 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 as well as supply—that is, the money 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 loans are made at lower loan-to-value (LTV) ratios, thus reducing leveraged cash flows and property values.

These changes in capital flows can also have a direct impact on the supply and demand dynamics for a 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.

The cost of capital and capital availability affect supply by providing additional capital for property development.

Discount Rates

The most evident impact of interest rates on real estate values is visible 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 (required rate of return), while the capitalization rate equals (K - g), where g is the expected growth in income or the increase in capital appreciation.

Each 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. Guaranteed by federal government credit, 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 investment considered.

Because the discount rate (K) 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.

The Bottom Line

It 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.

That 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 an increase in risk, risk premiums widen, putting stronger downward pressure on property prices.