As a real estate investor, you’re probably curious about how interest rates can affect the value of your investments, or the value of any investments you might be considering. Whether you own rental properties, invest in real estate funds, or invest in real estate online through crowdfunding websites or other intermediaries, it’s crucial to understand how interest rates affect real estate investments.
Let’s begin with a few basic facts from Econ 101. Interest rates affect the present value of future cash flows; when interest rates go up, present value goes down, and when interest rates go down, present value goes up. If we apply this rule to real estate investments, it become clear that when interest rates go up, the value of real estate goes down, assuming that all other variables remain constant. Why is this? When interest rates go up, investors begin to demand higher returns for all investments. However, since returns for real estate investments remain unchanged (i.e., income generated by the properties does not change), they become comparatively less attractive to investors and lose value accordingly. Conversely, if interest rates go down, real estate investments increase in value.
In terms specific to real estate, when interest rates rise, cap rates (net operating income / current market value) also have to rise, but cash-on-cash returns (cash flow / cash invested in the property) remain the same; as a result, property values have to fall.
There are four main reasons why interest rates change: inflation, bond supply, bond demand, and actions taken by the federal reserve. Whatever the reason, it is important to keep interest rates in mind when considering a real estate investment.