Interest rates and property prices: the actual relationship

The relationship between interest rates and property values is real, and it operates through several distinct channels that move at different speeds.

Channel one: loan sizing

The most direct and the fastest.

Commercial loans are sized on debt service coverage. When rates rise, a given NOI supports a smaller loan, because the payment per dollar borrowed is larger.

A buyer using seventy percent leverage who can now only obtain fifty-five percent must either bring substantially more equity or bid less. Most bid less.

This compresses prices without any change in the property's fundamentals, and it happens as soon as new loans are quoted at the new rate.

Channel two: required returns

Real estate competes with other assets for capital.

When risk-free Treasury yields are very low, a five percent cap rate represents a meaningful spread and attracts capital. When Treasuries yield four to five percent, a five percent cap rate on an illiquid, management-intensive asset represents almost no premium for risk.

Investors demand higher cap rates, which mechanically means lower prices for the same income.

This channel moves more slowly, because sellers resist and transactions simply stop for a while.

Channel three: affordability, in residential

For owner-occupied housing, monthly payment capacity is the binding constraint for most buyers.

The arithmetic is stark. A $2,000 monthly payment supports roughly $372,000 of principal at three and a half percent over thirty years, and roughly $250,000 at eight percent.

The same buyer, same income, buying a third less house.

In theory this should push prices down sharply. In practice it frequently does not, for the reason below.

Channel four: the lock-in effect

The channel that surprised people, and it works in the opposite direction.

In the United States, homeowners hold long-term fixed-rate mortgages. When rates rise well above their existing rate, moving means giving up that loan and taking a much more expensive one on the replacement house.

So they do not move. Listings collapse. Inventory falls to historically low levels.

Reduced supply offsets reduced demand, and prices hold or even rise despite affordability having deteriorated badly.

This is why the residential market behaved so differently from what a simple affordability model predicted. Volume fell dramatically. Prices did not.

It also means the effect is asymmetric across countries. In markets where variable-rate or short-fixed mortgages dominate, rate increases transmit to household budgets quickly and there is no lock-in, so the price response is faster and larger.

Channel five: replacement cost and new supply

Higher rates raise construction financing costs, which makes development less viable and reduces new supply.

That is a supportive factor for existing property values, with a lag of several years, and it seeds the next cycle's shortage.

Why the net effect is hard to predict

Because the channels have different signs, different magnitudes and different speeds.

Rising rates simultaneously reduce buying power, raise required returns, restrict supply of listings and restrict new construction. Which effect dominates depends on the segment, the market and the mortgage structures that prevail.

Commercial real estate, financed with short-term debt and priced on cap rates, transmitted rate increases quickly and repriced substantially.

Owner-occupied residential, protected by long fixed-rate mortgages, transmitted them into transaction volume rather than price.

Two segments, one rate environment, opposite outcomes.

What this means for underwriting

Do not underwrite cap rate compression. A model that assumes exit at a lower cap rate than entry is forecasting that rates will fall or that buyers will accept less. That is a bet on the macro environment, not on the property.

Underwrite an exit cap at or above entry, and be pleased if you are wrong.

Stress the refinance. Model the loan at maturity at rates well above today's, and check whether the property supports the balance.

Prefer the fundamentals you control. Rent growth from operational improvement, expense reduction and physical improvement are within your influence. Rates are not.

Deals that only work because of an assumed rate environment are macro positions with a building attached.

The honest limit

Nobody forecasts rates reliably, including the institutions that set them.

Which argues for structuring so that you do not need to. Long fixed debt, conservative coverage, and returns that come from the property rather than from the discount rate.

General information about real estate markets, not investment advice. Rate environments and their effects vary by market and instrument. Consult qualified professionals about your own circumstances.