What now, now that interest rates look like they’re rising?
In my last article, I discussed how higher interest rates might impact the different assets you hold in your investment portfolio. In that article, I briefly explained how central banks use interest rates to attempt to control inflation and economic growth. I also touched on how higher rates might impact property prices. In this article, I expand on what might drive interest rates higher and discuss how higher interest rates could impact property prices in a little more detail.
The primary drivers of interest rate changes
There are three primary drivers of interest rate changes.
Perhaps most important is inflation. When inflation rises or is expected to rise, consumers tend to spend more earlier. It is to beat inflation – something that costs £10,000 today may cost £10,500 next year. So, consumers think it’s better to spend now rather than pay more in the future. It pushes inflation higher, and forces central banks to increase interest rates to try to dampen demand.
When governments issue bonds (via central banks), increased supply pushes interest rates down. Conversely, when bond supply falls below demand, issuers are forced to increase rates to entice buyers. Central banks will issue bonds to try to push interest rates lower – such as they have been doing in the years since the Global Financial Crisis. This vast and concerted effort caused interest rates to fall and pumped trillions of pounds into the investment markets around the world. We now know this as quantitative easing (QE).
The amount of QE is being pulled back around the world, and so we would expect interest rates to rise. Also, inflation is increasing – particularly here in the UK, primarily because of the fall in the value of sterling following the vote to leave the EU.
What effect do higher interest rates have on an economy?
When the Bank of England increases interest rates, banks and other lenders will raise their lending rates. Anyone who wants to borrow money will have to pay more for the privilege of doing so. On the face of it, this is terrible news. However, this isn’t so for everyone. Sure, individual borrowers, companies with debt, and governments that borrow to spend will all be worse off, but there will also be some winners, too. For example, people investing in bonds will be able to earn more income, as will cash savers.
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However, those who already own bonds will see their value fall (that’s the result of the inverse relationship between bond prices and yields). Investors who hold equities may see the value of their investments fall, too, as corporate earnings get squeezed between higher borrowing costs and lower consumer spending. It tends to send share prices lower.
So, as I described in my previous article, stock and bond prices tend to react negatively to higher interest rates. It isn’t necessarily the case for residential property investment values.
How residential property investment prices react to higher interest rates
If we took interest rates on their own, and as the only factor affecting property prices, then apparently higher interest rates would have a negative impact. As an investor, you will pay more in mortgage interest. It affects the future cash flow of your investment property.
Consider if you earn, say, £15,000 per year in rent and pay, say, £5,000 in mortgage interest payments. Your net income is £10,000. If investors want to make a net yield of 7%, then the value placed on your property is £143,000. Now, if interest rates rise and your mortgage interest payments increase to £7,000, then for the net yield to remain at 7%, the value of the property would have to fall to around £114,000.
In other words, if investors believe that interest rates will rise further, they will want to buy at a discount to the current value to achieve their desired income yield.
However, with property prices, things aren’t quite so clear-cut. For example, if interest rates are rising because of inflation, the likelihood is that rents will be rising too. In fact, it is often the case that rent inflation outpaces general inflation. Hence, if rent increases compensate for or even outpace interest rates, then property prices could rise despite higher interest rates.
Higher interest rates may decrease future cash flow on your investment property, but inflation could increase cash flow. Also, because higher interest rates make buying a home more difficult for many (as well as the psychological effect), they often lead to increased demand for rental properties – thus putting further upward pressure on investment property values in the best places to invest in property UK.
The secrets to profiting in an economic environment in which interest rates are rising are to:
- Understand the property and economic trend cycle
- Always buy where the property fundamentals are strongest
- Get the best financing possible
In my next article, you’ll learn how to prepare for higher interest rates when you own an existing property portfolio. In the meantime, you can discover how property could increase your investment profits as interest rates rise by contacting one of the Gladfish team today +44 207 923 6100.
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