High leveraging is the way to get maximum returns from any real estate investment. In most cases, leverage percentage is about 60-80% of the total property value. This means the real estate industry relies heavily on debt financing. Debt financing is directly impacted by the market interest rates. Hence, as soon as interest rates change there are dynamic shifts in the real estate industry as the cost of capital increases.
T-bonds or risk free bonds are the federal investments that have zero risk associated with them. In order for a real estate investment to be an attractive channel of investment the returns associated should be higher than the T-bond rate of return.
T-bonds Real Estate investments have a risk associated with them due to several external factors. This risk is referred to as the risk premium which is added to the risk free rate to give the risk adjusted return. This is essentially the return expected from the real estate investment. As the interest rates rise the risk adjusted return is thus pressured outward for the investment to yield significant return above the risk free rate. Hence, as the cost of capital rises the rate of return decreases. In order to restore the rate of return, investors start offering much lesser purchase prices. As a result property valuations start decreasing over time.
As market conditions shift dramatically due to changing interest rates and as there is a gap between buyers and sellers that is still settling; investors move on to other modes of investments due to reduced attractiveness of real estate returns. As a result demand reduces which further drives down the valuation of properties.
Also as the interest rates rise lenders become cautious about the loan amounts processed and as a result there are lesser loan proceeds in the market. This means access to capital is further reduced thus affecting the number of investments made in properties. As the supply increases demand naturally reduces thus directly affecting property valuations.
All in all rising interest rates are a great indicator of short term market activity.
