Do artificially low interest rates inflate the value of real estate?
Since the 2008 US mortgage crisis, which led to one of the worst economic downturns in living history, worldwide interest rates have been held artificially low as a means of stimulating economic growth. While economic growth in areas such as the UK, US and some parts of Europe is only now starting to come through, four years after the downturn, there is concern that artificially low interest rates do give an artificial impression of the worldwide real estate market.
On the surface it would make sense to come to this particular conclusion but if you dig a little deeper, and look at general investment costs, perhaps the ongoing improvement in worldwide real estate prices is not as overdone as some may think.
The cost of investment
When looking at any investment, whether property, stocks, shares or anything else you can think of, the first ingredient to take note of is the cost of finance and maintaining the value of the asset involved. The fact that base rates are artificially low, currently 0.5% in the UK for example, and inflation is relatively low, around 2% in the UK for December, makes the required return on investment lower than normal. In simple terms, the cost of finance is 0.5% and inflation is 2% so in theory any return over 2.5% will at least maintain the value of the funds invested, putting aside changes in the actual value of the property.
Quote from PropertyForum.com : “It may well be that problems within Europe are forcing European and American real estate investors to look elsewhere but there is no doubt that interest in the Asia-Pacific is growing.”
This may well explain why some overseas investors are keen to invest in prime London property despite the fact that some of the rental yields are less than 3%. In the real world this is obviously a situation which cannot go on for much longer and, as base rates rise, so will the cost of finance and the investor returns required to “standstill”.
Chasing a buoyant market
Despite the fact that the UK economy, as one example, is beginning to pick up, the Bank of England has already confirmed that base rates will not rise in the foreseeable future. This therefore gives property investors a window of opportunity in which to take advantage of rising property prices and hopefully sell before the market turns. As with any investment market, the property market will look forward beyond the current situation and potentially price in (to a differing degree) expected interest rate movements over the next 12 to 18 months.
It is very difficult and often very dangerous to chase markets which are based upon artificially low interest rates such as we have today. Any rise in base rates today would have an impact upon some of the more buoyant property markets around the world and potentially leave some investors high and dry, having bought in at the top end of the market. That said, UK base rates are expected to remain steady for some time to come and who knows what other economic woes we have on the horizon in the USA and Europe?
Conclusion
While there is no doubt that artificially low base rates have an impact upon property markets, reducing the cost of finance and therefore the return on capital required to “standstill”, many investors are happy to look at the short to medium-term outlook with regards to their property assets requirements. Whether they will need to sell up before the interest rate cycle turns to at least maintain their financial firepower going forward remains to be seen but chasing markets based upon effectively artificial base rates, introduced for a specific reason, i.e. economic recovery, is not for the fainthearted.