Low Interest Rates and Property Values
By Charlie Elliott, Jr., MAI, SRA

With interest rates reaching and remaining at historic lows for a relatively long time, we are hearing more and more warnings that they cannot stay down long term. When interest rates do increase, what effect can we expect on mortgage loan originations as well as the housing industry? What effect will it have on property values?

Many, if not most of you, are too young to remember when interest rates began their 22-year downward spiral in 1981. At that time rates were at around 18%, and few people could afford to purchase a home or, at least, not a very expensive home. The home construction industry was brought to a virtual halt, and home sales volume slipped to levels below 50% of what they had been in recent years.

This, more than any other factor, contributed to the downfall of the savings and loans in the ‘80s. These institutions had portfolios of loans made in years past at rates generally between 6% and 8%. These loans were funded generally from passbook savings accounts and certificate of deposits at rates of 3% to 5%, providing the thrifts with a margin of 2% or 3%. When mortgage rates went up, so did the thrifts’ cost of money. They found themselves paying rates as high as the mid-teens to support a portfolio of loans generating approximately half that rate. Since the thrifts’ loan portfolios contained few variable rate loans, large numbers of them went out of business and the federal government was forced to bail them out, costing taxpayers billions of dollars. Many builders went out of business during this period, and banks foreclosed on many construction loans. Homeowners with variable rate loans felt the pinch, and many people were unable to purchase homes for an extended period of time. To put it simply, all hell broke loose in the housing industry.

Contrary to the negative effect of the enormously high rates of the early ‘80s, recently we have been on a sort of interest-rate honeymoon, especially in the past few months. Recent mortgage rates, as low as 4%, have sent homeowners on purchasing and refinancing buying spree.

So much for the history lesson, but it doesn’t hurt to reflect upon the events of the past. Perhaps we have all heard the statement, “The only thing that history teaches us is that history doesn’t each us anything.” As professionals, we cannot afford to bury our heads in the sand and ignore what is likely to be coming down the tracks. Those of us who plan to remain in this industry must learn something from history. You don’t have to be any kind of expert to get a feel for what would happen to the housing market if interest rates returned to the high teens. Frankly, thanks to the efforts of Alan Greenspan holding inflation in check, it is possible, but not likely, that we will experience interest rates in the high teens any time soon.

We are, however, certainly going to experience cyclical fluctuations in interest rates. Given the historically low rates, it is likely that rates will increase in the near future, and it could be a significant increase. When this happens, it should not come as a surprise. Those of us who are most prepared and have the best understanding of the forces of the market can best deal with it in our business.

It is not if interest rates will increase but when. Federal government spending is on the rise, and near-term government deficits are projected to be the highest ever. We will all be competing with the government for the pool of available money. Rates on certificates of deposit and other money market funds are so low that they are producing virtually no material return. Banks have the gall, in some cases, to actually pay less than 1% on short-term investments, such as savings accounts. One bank here in my town has been paying ½ of 1% on savings accounts. Anyone pretending to live on the return of such investments will find the task difficult, to say the least. This situation encourages investors to place their money elsewhere, further removing money from that pool of funds available for mortgage lending. When the supply gets short, guess what; the demand increases, and you know the rest of the story.

As evidenced above, when rates head north there are many negative effects, which may be experienced. Since my lot in this industry is to deal with appraisals and to assist in the assessment of collateral being used for loans, I direct your attention to the effects of rising interest rates have on value.

When we consider the effect interest rates have on value, let’s consider the effective difference between an interest rate of 4% and that of 6%. Let’s consider the home that is financed at 100% and is purchased for $200,000 using a 4% loan, which we will consider to be the lowest rate in the interest rate cycle. Let’s further consider that, a number of months later, interest rates have increased to 6%, an increase of two percentage points. To many of us, an increase of 2% doesn’t sound like much. Even if we take the position that this 2% rate increase comes straight off the value of the property, in cases of appraisal questions, a 2% decrease in value does not make that much difference in value. The house would now be worth $196,000, right? Wrong!!

Upon closer inspection, our buying power did not decrease 2%. How about a 33% decrease in buying power? That’s right; do the math: 2% over 6% is equal to 33%, not 2%. Therefore, the buyer who bought a $200,000 home at a 4% rate now has the buying power to buy a $133,000 home.

Now, I am not going to suggest that an increase of 2% in interest rates is going to cause property values to decrease 33%, but such an increase can, and perhaps will, cause substantial decreases in the values of properties. This is especially true in areas where property values already are unstable, such as in areas where overbuilding has occurred or areas that are falling out of favor with the market.

So how much will a couple of points in interest rate increases negatively affect property values? Every property is different, and admittedly such a prognostication is a matter of professional opinion. In some cases, it may just work out that values increase slower or stop increasing. In others, a modest decrease may be expected in the amount of say 1% to 2%. Then, there will be those properties in those at-risk areas where we may experience a 5% to 10% decrease. Also, don’t forget we are just proposing a 2% increase. A larger increase of, say, 3% or 4%, taking long-term interest rates to, say, 8% or 9%, which we experienced not long ago, could have a more pronounced effect.

These numbers are general and subject to differing opinions, but few people in the know would take exception to the premise that rising interest creates downward pressure on property values. Expect that to happen as interest rates rebound.

Charlie W. Elliott, Jr., MAI, SRA, is President of ELLIOTT® & Company Appraisers, a national real estate appraisal company. He can be reached at (800) 854-5889 or at charlie@elliottco.com or through the company’s Web site at www.appraisalsanywhere.com.