As of December 2018, The Federal Reserve Open Market Committee (FOMC) had bumped up the federal funds rate for five consecutive quarters. Although Federal Reserve Chairman Jerome Powell signaled a slow down of increasing rates in the committee’s meeting in January 2019, there is still optimism that the U.S. economy will grow in the near future amongst FOMC members, meaning the possibility of further increases in the future.1
The federal funds rate is what the Federal Reserve charges its member banks to borrow money. And, that rate can impact everything from bond and Treasury bill rates of return, to mortgage rates. As such, it seems as though whenever the Fed makes some kind of move on the federal funds rate, one question asked is how that action will impact the real estate sector.
The immediate answer could be: “A lot.” A higher interest rate could mean borrowing money becomes more expensive. This, in turn, could mean real estate will cost more. Higher interest rates could impact rates of return on a real estate investment, as it could lead to higher capitalization (cap) rates, weaken the value of property and hurt investment performance. Cap rates are determined by net operating income and asset value; the higher the cap rate, the lower the property value.
Though the above could represent a doomsday scenario, the truth is that an interest rate is only one variable impacting real estate investments.
Let’s take a look at the following myths and realities of interest rates:
1) Myth: Higher interest rates will mean lower returns; increasing interest rates will decrease the value of future cash flows.
Reality: Many variables determine cash flow values, not just interest rates. Expenses, from increasing property taxes to property management fees, can impact your cash flow. Geographic location can, also. Your property’s age can also be a determining factor because of increased costs due to capital improvements. Interest rates are not the sole factor.
2) Myth: Increasing interest rates mean investors will demand a higher rate of return. This, in turn, could lead to a lowering of the value of property, making real estate investments potentially less attractive.
Reality: Again, other issues -- primarily economic – can impact your asset’s value, not just an interest rate boost. For example, inflation could increase the value of your asset, wiping away any potential decline from an interest rate boost.
3) Myth: Higher interest rates will lead to a higher cost of borrowing, meaning fewer will be able to obtain mortgages to buy real estate.
Reality: Let’s keep in mind that the Fed doesn’t increase its discount rate without reason. More often than not, the rate is increased in an attempt to control inflation and/or because the economy is on sound footing. Furthermore, loan interest rates may be floating and dependent on certain indices unrelated to the discount rate set by the Federal Reserve:
- The London Interbank Offered Rate, or LIBOR. This is the average interest rate at which major international banks borrow from one another. LIBOR is common among adjustable-rate mortgages and business loans, as well as financial tools traded on the global financial markets.
- The Cost of Savings Index, or COSI. COSI is a bank-specific index, representing that bank’s certificate of deposit account interest rates, versus the Fed’s discount rate. The COSI, is, however, available in only certain banks.
4) Myth: A higher interest rate will automatically mean a higher cap rate. And a higher cap rate will erode a property’s value.
Reality: A higher cap rate could mean a drop in the asset’s value. But interest rates and cap rates don’t move in lock step. Rather, cap rates can be influenced by issues such as local market trends, capital flow, real estate fundamentals and investor risk appetite.
Do Not Panic
The takeaways from this discussion are that, first of all, higher Fed discount rates may be in our future. The Federal Reserve likes the economy’s improvement, and will continue to moderately increase that discount rate. But second, relying solely on discount rate increases to predict what will happen to the real estate sector represents narrow thinking.
The relationship between interest rates and real estate is fairly complex. As a result, the rise and fall of the discount rate is only one issue to consider when determining the best type of investment for your portfolio.
Realized 1031 offers intelligent insight, options and advice about real estate investments, no matter how the Federal Reserve is handling the discount rate. For more information on if – and how – discount rates can impact your holdings, contact Realized 1031.
- Paris Ward. Why did the Fed halt interest rate hikes? Now we have more insight. Credit Karma. April 17, 2019.