By: Nathan Metheny, Managing Principal/Co-Founder
Interest Rates and Real Estate
Over the course of the past year, interest rates, and more specifically the federal funds rate, have been a major topic of conversation. Before we recognize why this is a major topic and how it affects real estate investment, we have to first understand what the federal funds rate is.
Understanding the Federal Funds Rate
As a simple definition, the federal funds rate can be outlined as the interest rate that banks lend capital to other banks on an overnight basis. According to law, all depository institutions are required to maintain a minimum reserve, known as the reserve requirement, at Federal Reserve banks to ensure each bank has the necessary means to settle depositors’ withdrawals and all other financial obligations. If a bank expects to have sum greater than its reserve requirement, it can lend that surplus to other banks that expect a shortage of the requirement; the interest rate that it can charge is referred to as the federal funds rate.
The overseeing entity guiding interest rates is the Federal Open Market Committee, or the FOMC. The FOMC’s main purpose is to prolong economic growth in prosperous times and prevent/limit the length of recessionary periods. In order to determine the federal funds rate, the FOMC takes into account information regarding the current economic climate such as employment, inflation rate, and other indicators. The Federal Open Market Committee cannot actually force the banks to charge the set interest rate, but they can target the rate through manipulation of the money supply within the economy. If the Federal Reserve decreases money supply, interest rates rise; an increase in the money supply causes rates to fall. Typically, lenders base their short-term interest rates, which are the rates provided on everything from home loans to auto loans, on the prime lending rate. The prime lending rate is strongly correlated with the federal funds rate; when the federal funds rate increases, the prime lending rate shortly follows.
Outcomes of Interest Rates on Real Estate
Recently, the fed has cut interest rates in the face of the current economic boom with the hopes of prolonging the period of growth. Since the start of 2019 the fed have decreased the federal funds rate from 2.25% to 1.50%. So how does this decrease in the federal funds rate affect the real estate market?
1. Higher Yields: Investors always want to know how much profit is expected before investing capital. To forecast the expected yield, the net operating income (NOI) must first be calculated. The NOI is the gross income minus the forecasted operating expenses. Once you have the NOI, the cost of financing is deducted, providing the net income or the net cash flow (NCF). Lower interest rates cheapen the cost of financing, boosting the NCF. For example, decreasing the interest rate on a $1,000,000 loan amortized over 25 years with a 5% interest rate to 4% would increase profits by nearly $200,000 over the life of the loan. Decreasing the interest rate on a $5,000,000 loan amortized over 25 years with a 5% interest rate to 4% would increase profits by $3,000 per month; a whopping $850,000 over the life of the loan.
2. Property Values: Property values are determined by an investment’s NOI and current market cap rates. As seen above, the NOI does not include the cost of financing which would be cheaper with decreasing interest rates. Although lower interest rates do not have a direct impact on property values, you may see an indirect effect; due to the higher yields, investors may be more willing to pay a premium for investments. Read more about how to value an asset with the use of capitalization rates.
While falling interest rates may be a positive for the real estate landscape, the market can always act unexpectedly. Lowered rates will undoubtedly improve confidence within current investors; current stakeholders in investments hold the opportunity to refinance the investment at more favorable costs, also providing a hedge against a potential market downturn.
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Disclaimer: Information contained herein should not be considered investment advice. Wealthrise makes no representations or warranties and accepts no liability. We suggest that you consult with a tax advisor, CPA, financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and risk implications associated with any investment.
About the Author: Nathan Metheny is Co-Founder and Managing Principal at Wealthrise. In this capacity, his primary roles include acquisition supervision as well as setting the long-term strategy and trajectory for the company.