Interest rates are critical in the evaluation and performance of any investment primarily because of their impact on the present value of future cash flows. The unprecedented actions taken by the Federal Reserve as a result of the 2008 financial crisis, produced a quantitative easing program on a scale never before seen — more than $2 trillion dollars. As a result, there has never been a more important time for investors to be aware of the impact that potential rising interest rates can have on their portfolio.

Below, we outline what factors influence interest rates and what rising interest rates mean for the real estate industry.

What causes interests rates to rise?

Experts point to four key drivers of changing interest rates: inflation, bond supply, bond demand, and the Federal Reserve. As inflation expectations rise, consumers believe they will lose purchasing power in the future (i.e. their money will be worth less). This leads to increased interest rates to compensate for the perceived loss. Increased supply in the bond markets can also lead to higher rates, as issuers are forced to borrow at higher interest rates based on supply and demand dynamics. Inversely, a decrease in bond demand will lead to higher rates, as issuers will offer investors a higher return in order to raise capital. The Fed attempts to manipulate these drivers by buying and selling assets effectively controlling the market. Although the Fed has the intention of suppressing rates by buying bonds (over supply the market with capital), this action can also raise inflation expectations, potentially offsetting any impact on actual interest rates.

How does this impact real estate values?

When changes in interest rates are viewed as an independent variable (that is, they change while everything else remains constant), their effect on real estate is simple and clear. At the end of the day, the value of any investment is the sum of the future cash flows from that investment, discounted back to present value. As interest rates rise, the value of any future cash flow decreases, which in turn lowers the value of the asset (real estate property). Another way to look at this is that higher interest rates cause investors to demand a higher return, which makes any property less appealing given the return on that specific investment remains unchanged.

However, interest rates never change alone, so it is useless to analyze the potential effects on real estate value without thinking about the other factors that may occur in tandem with changing rates!

When it comes to real estate, the relationship between inflation and rising interest rates becomes more complex. Inflation is often the critical driver of interest rates, and as such the two typically move together. While rising interest rates can reduce the value of future cash-flows, inflation can in turn increase the value of physical property due to the fact that real estate is a hard asset (see our blog post Real Estate is a Hard Asset). Ultimately, if the increase in property value from inflation outweighs the decrease caused by rising rates, the net result can be positive. This fact has made real estate one of the most sought after investment classes in periods of rising rates because of its ability to weather the storm of inflation.

Why does this matter to investors today?

The Fed’s quantitative easing program has resulted in the unprecedented purchase of over $3 trillion in assets. While certainly up for debate, the goal of the QE program was to stabilize prices for these assets, maintaining demand in the marketplace and effectively lowering their yield.

Surprising to many, there has been little to no inflation as a result from the vast sum of money the Fed has injected into the economy. Some attribute this lack of inflation to banks being hesitant about lending, effectively keeping supply of capital artificially low. However, with the economy continuing to show signs of a stable recovery, many believe that banks will increase their levels of lending, which would flood the market and quickly drive up inflation. This, in combination with the Fed slowing its asset purchases, could lead to significant increases in interest rates.

The possibility of rising interests rates is an important factor to consider in any investment decision.Fixed-income investments are a necessary part of a diversified portfolio, but most fail to offer the same protection against inflation that real estate does. With the increasing possibility of rates rising substantially in the near future, most experts agree that real estate is a particularly attractive investment in today’s market.