good question. a local CA guru called bruce norris has been answering that question for 10 years. only the question is "what causes real estate values to rise and fall".
the short answer is
1. net migration
2. affordability
3. interest rates (which has a direct relation with affordability)
4. unemployment.
all these factors have an effect on property prices.
What in the world is net migration? It sounds like something to do with crabbing, birding, or the internet. lol
Oh, it must be the net result of people migrating to an area. Is that it? 8-)
If supply is greater than demand, house values may actually go down or they may just level off.
I am not an econimist for sure. But I have watched many different areas very closely in the Chicagoland suburbs for several years now and it has been very educational and interesting. And it makes sense.
In the far west and southwest suburbs, developers are building like crazy. Despite the all time low in interest rates, there is far more supply than demand.
(In a few suburbs where I own houses, there has been no appreciation at all because newer, nicer houses can be had today for a little more than what FMV was on mine 5 years ago. This particular home to which I refer has sold comps over the last 5 years in the 190's. 5 years ago, a house down the street sold for 189k. The house right across the street just sold for 195K 3 months ago.)
Also, foreclosures are high. There were over 3000 cases filed in this county in the year 2003, alone. This also contributes to supply.
When interest rates go up, there will be less buyers, and that will increase supply even more.
As interest rates go up, people with ARMs will have higher payments. Many will not be able to afford higher payments and they will have to sell, or face foreclosure, again increasing supply.
Again, you don't have to be an economist to know that when there is a lot of supply, prices will flatten out and if there's too much supply, prices will go down.
I haven't seen the statistics on this, but from talking to many people in financial distress and from my tenants, it seems that jobs haven't fully recovered in our area yet. And though people can get jobs now, they are for less pay than people were seeing 3-4 years ago.
And I see far more people being transferred out of our area than I see being transferred into our area.
Until that turns around, it just adds more to the supply problem.
On the other hand, suburbs closer into the city are out of land to build, so many people are tearing down old 1800-2000 sf homes and building 4500-5000 sf homes on the same lot. This is increasing the FMV of whole neighborhoods so that while you may not increase the size of your home, the whole neighborhood is increasing in value which increases the value of your home. (Unfortunately these homes are in the half million to million dollar price range and do not cashflow whatsover - but that's a seperate issue.)
I don't know what the market is for these homes, but I do know that because you can't build more in these areas, supply is limited to the number of people who want to move.
In this case, interest rates will affect the demand, because 1 point on a more expensive home like this is a much bigger payment than on a less expensive home, so I would expect demand to be less. But supply is already low, so perhaps this market will still appreciate, though probably less than when interest rates were low.
Just some of my observations.
My research shows that Florida has some other things going for it. You have the baby boomers retiring south for the winter as a major factor.
On the flipside, I wonder how the hurricanes have affected people's decisions to leave the state or thwarted plans of moving there. Thinking out loud, perhaps people have only delayed their moves. If the next couple years are not as bad as this one was, it may not be much of a factor.
BTW I am actually in the process of moving south myself, though not as far as Florida.
Quote:
On 2004-12-21 14:15, melissa wrote:
My research shows that Florida has some other things going for it. You have the baby boomers retiring south for the winter as a major factor.
On the flipside, I wonder how the hurricanes have affected people's decisions to leave the state or thwarted plans of moving there. Thinking out loud, perhaps people have only delayed their moves. If the next couple years are not as bad as this one was, it may not be much of a factor.
BTW I am actually in the process of moving south myself, though not as far as Florida.
So far in Florida the RE market is STILL booming, with no sign of slowing down. This is good for me because as soon as my properties sell, I am outta here (I never did like FL - born and raised and decided 28 years in a state you hate is plenty).
I think if we have another bad hurricane season we would start to see some slowdown, but right now people see it as a freak occurrence and nothing to fear in the future.
I will add that insurance is becoming a greater problem. Even people with relatively brand new houses (3 yrs old) are having trouble finding insurance. Rental insurance is really hard, and harder yet if the properties are 50yrs old (like mine).
By definition, interest rates create a net negative drag on real estate prices. That being said, they don't necessarily result in a reduction in prices.
Think of real estate prices as the middle of the rope in a tug of war. On each end of the rope, there are various forces pushing the prices up and down.
Impact on pricing would be elements like...
Supply of real estate in a given market (low supply = upward pressure, high supply = downward pressure)
Demand of real estate in a given market (increasing demand due to population increases = upward pressure, decreasing demand = downward pressure)
Consumer confidence (high confidence = more commitment to buying big ticket items like houses, low confidence = less commitment)
Interest rates. Higher rates = higher service costs (downward pressure), lower rates = lower service costs (upward pressure).
Relative yields. Investors look for where their money does the most. If bonds pay very well compared to real estate, they will steer away from real estate. If the stock market is booming, investors will steer more money towards equities and away from real estate.
How much interest rates specifically come into play will be a function of the type of real estate, and what other factors are in play. In the end, whether prices move upward and downward is the sum of the impacts of these factors.
Interest rates have the most direct impact on real estate when it is viewed as a business versus speculative investment. For example, if you're looking at raw land, many investors are concerned with capital gain value since there is little to no income. Carrying costs of mortgage is a smaller factor than price appreciation.
Whereas in commercial office/mutli-residential, investors are often looking at long-term income returns. Increased carrying costs have a more substantial correlation to the valuation of the property.
This is why a 200 basis point jump in interest rates may cut the price of an apartment building by 15%, but only have a nominal affect on raw land pricing and single family residential pricing.
This is also why you will often see real estate market movements are not synchronized. For example, you may see apartment building prices moving up, while residential housing is flat, and office buildings are declining.
They all have different valuation basis, and are all affected by the same economic factors in different ways.
Interest rates are certainly a big factor influencing home prices, however all housing markets are local so local factors such as employment, population growth and supply can have even more influence. I only can tell you about my area, Allentown, Pa. We have seen a 50% appreciation in prices in just the last couple of years. My gut tells me that this can not continue. That said I am going to keep my long term properties. I bought them because I liked them and that has not changed over the years. I suppose a stock market type crash in the real estate market is possible if rates suddenly rise and the market is overbuilt but money can be made in any market if you adjust your strategy. When I started in the real estate business the market was terrible; I was just to ignorant to know it. My prediction is that while prices will not crash the time needed to sell will increase greatly from what people are now expect (5 days) to a much greater number of days say.....270 days.
Galahad - If you don't mind could you explain in detail your statement that an increase in interest rate of 200bp can reduce the value of apartment building by 15%
.
Are you saying that if I buy an apartment building for 1 Million at 6% , 25 year amortization, and in 4 years, the prevailing rate in 8%, the actual value of the building has reduced by 15% to $850K?
Thanks
Quote:
On 2004-12-22 22:49, Galahad wrote:
Whereas in commercial office/mutli-residential, investors are often looking at long-term income returns. Increased carrying costs have a more substantial correlation to the valuation of the property.
This is why a 200 basis point jump in interest rates may cut the price of an apartment building by 15%, but only have a nominal affect on raw land pricing and single family residential pricing.
This is also why you will often see real estate market movements are not synchronized. For example, you may see apartment building prices moving up, while residential housing is flat, and office buildings are declining.
------
Galahad - If you don't mind could you explain in detail your statement that an increase in interest rate of 200bp can reduce the value of apartment building by 15%
------
Okay, I guess the best way to explain this is to put this in terms of investment valuations.
Essentially, when an investor looks at an investment, they are primarily concerned with their yield, or return on investment.
As a baseline, investors will use bond rates as their reference point.
For example, if a bond yields 5.00%, then an investor will expect other investment classes to yield a rate that is commensurate with the risk level.
In the case of equities, because the risk is higher, investors will expect a return rate (capital gains + dividends) that is well above the rate that a bond returns. After all, a bond is essentially 100% safe (let's not get into arguments over the soundness of the federal government).
In the case of real estate, the gauge that many investors use is the cap rate. Cap rate is essentially a basic yield calculation. Cap rate, being a calculation of income versus total investment price is directly analogous to earnings versus commercial equity (IE, total earning power versus the value of the asset).
What this means is this. Let's say that your bond rate is 5.00%. Then most investors would expect a minimum of a 7 to 8% cap rate before they would consider investing in real estate due to the overhead and risk associated (capital depreciation, management time/overhead, vacancy risk, etc).
If prime rates rise, this also generally translates into a rise in the expected bond yields. So let's say that bonds are returning 7.00%. Then investors would be justified in expecting a similar increase in yields on both business assets, equities, or real estate investments in order to justify the levels of risk.
To bring back this concept to that of real estate, let's do a hypothetical calculation.
Let's say that bonds are at 5.00% and the yield premium (expected cap rate) on real estate is 7.5%.
That would mean that if a property earned $75,000 per year, then an investor would be willing to pay $1,000,000 for that property (income/yield = $75,000/0.075).
If bond rates rose to 7.00%, then real estate expected yields would rise to 9.5%.
If the income of the property did not rise, then now the price to be paid in order to realize a 9.5% yield would shift downward. Using our same formula of income/yield, we get the following of $75,000/0.095 = $789,473. In this case, a 200 basis point rise would result in a resultant valuation decrease of approximately 21%.
Now, you may be saying what about internal rates of return? Won't investors take that into account?
Well, yes, some do. However, many of the larger institutional investors such as REITs, pension funds, and real estate conglomerates don't use IRR as a significant factor in their real estate purchases. Similarly, if you factor out price appreciation (which many investors do due to the long-term unpredictability of market pricing), your IRR rates drop significantly versus a pure mortgage pay-down scenario.
Additionally, the impact of higher interest rates has a direct impact on the affordability of commercial real estate. Since most major real estate prices are made on the basis of leverage, jumps in prime directly affects the amount of financing that a property can carry.
If you take our previous example, if you leverage $800,000 on a $1,000,000 property at 7.00% on a 20 year mortgage, your mortgage payments would be $6202.39/month or $74,428/yr. A jump of 200 basis points to 9.00% would increase your payments to $7197.81/month or $86,373/yr. In other words, an increase of 16% in your mortgage carrying costs.
This jump in carrying costs make the property less attractive and more difficult to market, placing further pressure on the pricing.
So in our current example, at $75,000/yr in revenue, the property just carries at 80% financing at 7.00%, making it a marginal positive cashflow property. However, in order for it to carry at 9.00%, your total financing that you could carry would be only $690,000 which would give you a mortgage cost of $6208.11/month or $74,497/yr. If you were limited to 80% leverage, this would make the maximum purchase price you could pay $862,500, or a substantive decrease in market value of 13.5%.
This of course, is not as relevant to single family homes and non-income producing properties as there can often be factors other than pure carrying costs associated with the market value. Home buyers are often concerned mainly with what they like, with the carrying cost being a secondary concern. Similarly, raw land generates little to no income so investors in raw land are often more concerned with development value or pure capital gains.
Great explaination! This is exactly what I had in mind.
I was thinking of buying a multifamily (10+ unit) property and knowing that rates are on the upside, I wondered how my property would sell after 5 years of holding it. In other words, if my carrying costs are at 6% interest rate and after 5 years down the road, if the rates are at 9% and I haven't been able to substantially increase my rents, I would have a tough time selling the property at the price that I want, unless I do some creative financing.
good question. a local CA guru called bruce norris has been answering that question for 10 years. only the question is "what causes real estate values to rise and fall".
the short answer is
1. net migration
2. affordability
3. interest rates (which has a direct relation with affordability)
4. unemployment.
all these factors have an effect on property prices.
What in the world is net migration? It sounds like something to do with crabbing, birding, or the internet. lol
Oh, it must be the net result of people migrating to an area. Is that it? 8-)
I guess it would depend on how high they climb.
If supply is greater than demand, house values may actually go down or they may just level off.
I am not an econimist for sure. But I have watched many different areas very closely in the Chicagoland suburbs for several years now and it has been very educational and interesting. And it makes sense.
In the far west and southwest suburbs, developers are building like crazy. Despite the all time low in interest rates, there is far more supply than demand.
(In a few suburbs where I own houses, there has been no appreciation at all because newer, nicer houses can be had today for a little more than what FMV was on mine 5 years ago. This particular home to which I refer has sold comps over the last 5 years in the 190's. 5 years ago, a house down the street sold for 189k. The house right across the street just sold for 195K 3 months ago.)
Also, foreclosures are high. There were over 3000 cases filed in this county in the year 2003, alone. This also contributes to supply.
When interest rates go up, there will be less buyers, and that will increase supply even more.
As interest rates go up, people with ARMs will have higher payments. Many will not be able to afford higher payments and they will have to sell, or face foreclosure, again increasing supply.
Again, you don't have to be an economist to know that when there is a lot of supply, prices will flatten out and if there's too much supply, prices will go down.
I haven't seen the statistics on this, but from talking to many people in financial distress and from my tenants, it seems that jobs haven't fully recovered in our area yet. And though people can get jobs now, they are for less pay than people were seeing 3-4 years ago.
And I see far more people being transferred out of our area than I see being transferred into our area.
Until that turns around, it just adds more to the supply problem.
On the other hand, suburbs closer into the city are out of land to build, so many people are tearing down old 1800-2000 sf homes and building 4500-5000 sf homes on the same lot. This is increasing the FMV of whole neighborhoods so that while you may not increase the size of your home, the whole neighborhood is increasing in value which increases the value of your home. (Unfortunately these homes are in the half million to million dollar price range and do not cashflow whatsover - but that's a seperate issue.)
I don't know what the market is for these homes, but I do know that because you can't build more in these areas, supply is limited to the number of people who want to move.
In this case, interest rates will affect the demand, because 1 point on a more expensive home like this is a much bigger payment than on a less expensive home, so I would expect demand to be less. But supply is already low, so perhaps this market will still appreciate, though probably less than when interest rates were low.
Just some of my observations.
My research shows that Florida has some other things going for it. You have the baby boomers retiring south for the winter as a major factor.
On the flipside, I wonder how the hurricanes have affected people's decisions to leave the state or thwarted plans of moving there. Thinking out loud, perhaps people have only delayed their moves. If the next couple years are not as bad as this one was, it may not be much of a factor.
BTW I am actually in the process of moving south myself, though not as far as Florida.
Quote:
On 2004-12-21 14:15, melissa wrote:
My research shows that Florida has some other things going for it. You have the baby boomers retiring south for the winter as a major factor.
On the flipside, I wonder how the hurricanes have affected people's decisions to leave the state or thwarted plans of moving there. Thinking out loud, perhaps people have only delayed their moves. If the next couple years are not as bad as this one was, it may not be much of a factor.
BTW I am actually in the process of moving south myself, though not as far as Florida.
So far in Florida the RE market is STILL booming, with no sign of slowing down. This is good for me because as soon as my properties sell, I am outta here (I never did like FL - born and raised and decided 28 years in a state you hate is plenty).
I think if we have another bad hurricane season we would start to see some slowdown, but right now people see it as a freak occurrence and nothing to fear in the future.
I will add that insurance is becoming a greater problem. Even people with relatively brand new houses (3 yrs old) are having trouble finding insurance. Rental insurance is really hard, and harder yet if the properties are 50yrs old (like mine).
By definition, interest rates create a net negative drag on real estate prices. That being said, they don't necessarily result in a reduction in prices.
Think of real estate prices as the middle of the rope in a tug of war. On each end of the rope, there are various forces pushing the prices up and down.
Impact on pricing would be elements like...
Supply of real estate in a given market (low supply = upward pressure, high supply = downward pressure)
Demand of real estate in a given market (increasing demand due to population increases = upward pressure, decreasing demand = downward pressure)
Consumer confidence (high confidence = more commitment to buying big ticket items like houses, low confidence = less commitment)
Interest rates. Higher rates = higher service costs (downward pressure), lower rates = lower service costs (upward pressure).
Economic growth. Higher growth = expanding industries and growing incomes (upward pressure), lower growth = stagnant/shrinking industries and stagnant/declining incomes (downward pressure).
Inflation. Higher inflation = upward price pressure. Lower inflation/deflation = downward price pressure.
Relative yields. Investors look for where their money does the most. If bonds pay very well compared to real estate, they will steer away from real estate. If the stock market is booming, investors will steer more money towards equities and away from real estate.
How much interest rates specifically come into play will be a function of the type of real estate, and what other factors are in play. In the end, whether prices move upward and downward is the sum of the impacts of these factors.
Interest rates have the most direct impact on real estate when it is viewed as a business versus speculative investment. For example, if you're looking at raw land, many investors are concerned with capital gain value since there is little to no income. Carrying costs of mortgage is a smaller factor than price appreciation.
Whereas in commercial office/mutli-residential, investors are often looking at long-term income returns. Increased carrying costs have a more substantial correlation to the valuation of the property.
This is why a 200 basis point jump in interest rates may cut the price of an apartment building by 15%, but only have a nominal affect on raw land pricing and single family residential pricing.
This is also why you will often see real estate market movements are not synchronized. For example, you may see apartment building prices moving up, while residential housing is flat, and office buildings are declining.
They all have different valuation basis, and are all affected by the same economic factors in different ways.
Hope that helps.
Just my 2c.
Galahad
Interest rates are certainly a big factor influencing home prices, however all housing markets are local so local factors such as employment, population growth and supply can have even more influence. I only can tell you about my area, Allentown, Pa. We have seen a 50% appreciation in prices in just the last couple of years. My gut tells me that this can not continue. That said I am going to keep my long term properties. I bought them because I liked them and that has not changed over the years. I suppose a stock market type crash in the real estate market is possible if rates suddenly rise and the market is overbuilt but money can be made in any market if you adjust your strategy. When I started in the real estate business the market was terrible; I was just to ignorant to know it. My prediction is that while prices will not crash the time needed to sell will increase greatly from what people are now expect (5 days) to a much greater number of days say.....270 days.
Galahad - If you don't mind could you explain in detail your statement that an increase in interest rate of 200bp can reduce the value of apartment building by 15%
.
Are you saying that if I buy an apartment building for 1 Million at 6% , 25 year amortization, and in 4 years, the prevailing rate in 8%, the actual value of the building has reduced by 15% to $850K?
Thanks
Quote:
On 2004-12-22 22:49, Galahad wrote:
Whereas in commercial office/mutli-residential, investors are often looking at long-term income returns. Increased carrying costs have a more substantial correlation to the valuation of the property.
This is why a 200 basis point jump in interest rates may cut the price of an apartment building by 15%, but only have a nominal affect on raw land pricing and single family residential pricing.
This is also why you will often see real estate market movements are not synchronized. For example, you may see apartment building prices moving up, while residential housing is flat, and office buildings are declining.
------
Galahad - If you don't mind could you explain in detail your statement that an increase in interest rate of 200bp can reduce the value of apartment building by 15%
------
Okay, I guess the best way to explain this is to put this in terms of investment valuations.
Essentially, when an investor looks at an investment, they are primarily concerned with their yield, or return on investment.
As a baseline, investors will use bond rates as their reference point.
For example, if a bond yields 5.00%, then an investor will expect other investment classes to yield a rate that is commensurate with the risk level.
In the case of equities, because the risk is higher, investors will expect a return rate (capital gains + dividends) that is well above the rate that a bond returns. After all, a bond is essentially 100% safe (let's not get into arguments over the soundness of the federal government).
In the case of real estate, the gauge that many investors use is the cap rate. Cap rate is essentially a basic yield calculation. Cap rate, being a calculation of income versus total investment price is directly analogous to earnings versus commercial equity (IE, total earning power versus the value of the asset).
What this means is this. Let's say that your bond rate is 5.00%. Then most investors would expect a minimum of a 7 to 8% cap rate before they would consider investing in real estate due to the overhead and risk associated (capital depreciation, management time/overhead, vacancy risk, etc).
If prime rates rise, this also generally translates into a rise in the expected bond yields. So let's say that bonds are returning 7.00%. Then investors would be justified in expecting a similar increase in yields on both business assets, equities, or real estate investments in order to justify the levels of risk.
To bring back this concept to that of real estate, let's do a hypothetical calculation.
Let's say that bonds are at 5.00% and the yield premium (expected cap rate) on real estate is 7.5%.
That would mean that if a property earned $75,000 per year, then an investor would be willing to pay $1,000,000 for that property (income/yield = $75,000/0.075).
If bond rates rose to 7.00%, then real estate expected yields would rise to 9.5%.
If the income of the property did not rise, then now the price to be paid in order to realize a 9.5% yield would shift downward. Using our same formula of income/yield, we get the following of $75,000/0.095 = $789,473. In this case, a 200 basis point rise would result in a resultant valuation decrease of approximately 21%.
Now, you may be saying what about internal rates of return? Won't investors take that into account?
Well, yes, some do. However, many of the larger institutional investors such as REITs, pension funds, and real estate conglomerates don't use IRR as a significant factor in their real estate purchases. Similarly, if you factor out price appreciation (which many investors do due to the long-term unpredictability of market pricing), your IRR rates drop significantly versus a pure mortgage pay-down scenario.
Additionally, the impact of higher interest rates has a direct impact on the affordability of commercial real estate. Since most major real estate prices are made on the basis of leverage, jumps in prime directly affects the amount of financing that a property can carry.
If you take our previous example, if you leverage $800,000 on a $1,000,000 property at 7.00% on a 20 year mortgage, your mortgage payments would be $6202.39/month or $74,428/yr. A jump of 200 basis points to 9.00% would increase your payments to $7197.81/month or $86,373/yr. In other words, an increase of 16% in your mortgage carrying costs.
This jump in carrying costs make the property less attractive and more difficult to market, placing further pressure on the pricing.
So in our current example, at $75,000/yr in revenue, the property just carries at 80% financing at 7.00%, making it a marginal positive cashflow property. However, in order for it to carry at 9.00%, your total financing that you could carry would be only $690,000 which would give you a mortgage cost of $6208.11/month or $74,497/yr. If you were limited to 80% leverage, this would make the maximum purchase price you could pay $862,500, or a substantive decrease in market value of 13.5%.
This of course, is not as relevant to single family homes and non-income producing properties as there can often be factors other than pure carrying costs associated with the market value. Home buyers are often concerned mainly with what they like, with the carrying cost being a secondary concern. Similarly, raw land generates little to no income so investors in raw land are often more concerned with development value or pure capital gains.
Hope that helps.
Galahad
Great explaination! This is exactly what I had in mind.
I was thinking of buying a multifamily (10+ unit) property and knowing that rates are on the upside, I wondered how my property would sell after 5 years of holding it. In other words, if my carrying costs are at 6% interest rate and after 5 years down the road, if the rates are at 9% and I haven't been able to substantially increase my rents, I would have a tough time selling the property at the price that I want, unless I do some creative financing.
Thanks.