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The relationship between interest rates and home values

Like every other investment vehicle, interest rates have a profound impact on real estate values. Because they influence an individual’s ability to purchase a home, there are many people who make the mistake of assuming the current mortgage rate is the only important factor in real estate valuation. 

Mortgage rates are only a single factor that affects property values. Since interest rates also influence capital flows, investors’ rates of return, and supply and demand for capital, they impact the price of property in more ways than one.  

How interest rates impact real estate values

When you consider fluctuations in interest rates as an independent factor, their impact on real estate values becomes clearer and easier to understand. Generally speaking, the value of any investment is equal to the sum of the potential cash flow generated by that investment, discounted back to current value. Increasing interest rates causes the value of future cash flow to decrease, which ultimately lowers the value of a property.

Another way to view this is that increasing interest rates lead investors to demand higher returns, which can make any property less desirable, since the return on that particular investment stays unchanged.

It’s important to keep in mind however, that interest rates do not change by itself, so gauging the possible impact on real estate value without considering other factors that may come into play along with the changing rates. 

Real estate values

Generally, real estate values are influenced directly by the supply and demand for available properties, as well as the cost of developing new properties. It goes beyond that however, as capital flows, financing rates, government-influenced interest rates, and other factors also affect property values.

In order to get a good grasp of these dynamics, a basic understanding of the income approach is crucial. This is the most widely used valuation method used by investors.

The income approach starts by forecasting property income, which is in the form of expected lease payments. After all property-level costs are factored in, the analyst will then get the net operating income or cash flow remaining after operating expenses. 

By eliminating all related capital costs, investment capital to repair or maintain property, and other non-property-related expenses, you get the net cash flow or NCF. Since a property does not typically retain cash, the NCF is equivalent to cash available, which is used by investors to value equity. Once you discount the cash flow stream or capitalize dividends for a specific investment period, you will then be able to determine property value. 

The importance of rising interest rates

In every investment decision, it’s very important to factor in the possibility of increasing interest rates. While a fixed-income investment is an integral part of any diversified portfolio, most of these do not offer the same protection against inflation compared to real estate properties. 

With the strong likelihood of increasing rates in the near future, many experts will agree that real estate will be a particularly attractive investment.

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