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What happens to real estate markets when mortgage rates rise
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What happens to real estate markets when mortgage rates rise

The mortgage rates in Europe and the US have been declining in recent years, falling to a record low in 2017, while property prices have been growing speedily.

However, in 2015 the US Federal Reserve (the Fed) began increasing the refinancing rate gradually. Many assume that the mortgage burden will also increase, following the Fed’s rate growth and putting pressure on property prices, as investors will anticipate higher return on investment.

All this begs the question – are rate adjustments really worth the worry? This report from Tranio.com delves straight into this question and provides a few recommendations for investors.

How mortgage rates have affected property prices

European countries and the US have been pursuing a general easy-money policy in order to revive their economies in the wake of the 2008 crisis.

As a result, an unprecedented event – the cost of money falling almost to zero, even to the negative values in some countries – has been taking place in the global economy over the last five years.

Mortgage loans in many countries have become almost free. For instance, according to Statista.com, between 2007 and 2016 mortgage rates in Germany decreased from 5.2% to 1.5%.

In 2017, German resident investors can buy flats with an 80% LTV mortgage at 1% per annum, rent them out and get yields of 3-4% per annum. Property owners can pay the mortgage with their rental income and enjoy annual property appreciation of 2-5%, depending on the location. The cost of financing is significantly lower than the rental rates.

In addition, bank deposits have stopped yielding and even become disadvantageous, as most European banks charge their clients for keeping money. People have to find alternative investment vehicles and thus increasingly opt for real estate, since this is a reliable way to invest with relatively high yields.

All of the above has led to a situation in which real estate asset owners do not want to sell their properties at reasonable prices: if the investors "go to cash", they will need to re-invest the money in something, and there are very few options. Having deposited money in banks, they will have to pay negative rates. This narrows the number of options in the market even further.

Property prices, mortgage rates and construction permits in Germany

The low rates have spurred demand for property, led to price increases in stable markets, and stopped price crashes in countries that suffered significantly in the 2008 crisis. According to Eurostat, between 2013 and 2016, residential property in Austria and Germany became 20% more expensive, while property in certain markets (e.g. Berlin and Munich) grew even more rapidly. During the same period, prices in Spain and Portugal bottomed out and started rising, and the markets of Australia, Hungary, Ireland, Canada, Poland and the US were growing actively.

The European real estate market of today can be characterised using the following metaphor: Germany is a bath, while the water is capital. the bath is full, and the water overflows to secondary markets – Hungary, Ireland, Spain, Portugal and the Czech Republic.

Conversely, the low rates have also augmented the supply, as more capital became available for construction. Over the last six years, thanks to cheap mortgages, the global market has received a huge number of metres, which would never have been constructed without such low-cost financing. The developers would not have started to carry out many of their projects, and the clients would never have bought the constructed properties.

Will a rate increase lead to a price reduction?

The situation in the lending market has begun to change in the last two years: the Fed has increased the refinancing rate on three separate occasions since 2015 and will probably do so two more times before the end of 2017: in June and in December.

The Fed raises the refinancing rate cautiously. Its goal is to find an effective balance between the risks of low rates and the desire to avoid hindering economic growth.

Mortgage rates depend on the refinancing rate. A rise in US interest rates may be followed by an increase in the rates in the UK and continental Europe. And it is unknown how the markets will behave if the rates begin to grow.

If the loan rates grow significantly, the investors will lose their buying capacity. Deposits will begin to yield again, though minimally. Most likely, construction volumes will peak by that time, and the supply of real estate in the market will increase: the owners will want to lock in their profits or reject burdensome mortgages and properties which have lost their liquidity.

All this may stop aggressive purchase growth and even cause a property price decline in peripheral locations.

For instance, a property in the US was bringing its investor a yield of 5% per annum with a treasury yield of 1%. the spread (or the investor's risk compensation) amounted to 4% per annum. Later, the general rate level increased and the treasury yield grew to 3%. It is logical for the investors (the potential buyers of the property) to require the same risk compensation as before. This means that the yield of such a property has to increase to 7%. This can happen either through a commensurate increase in rental income or a reduction of the price per m². Long-term rental contracts are rarely reviewed; therefore, only the second option — price reduction — remains viable.

According to our estimates, however, if and when the regulators begin raising the rates, they will do so not rapidly, but gradually; for this reason, no quick price adjustment is to be expected. But it is true that the growth limit has already been reached in many developed countries. Many investors understand that prices may go down. Such a risk is probable in locations where the population, income levels and the number of workplaces do not grow.

Our recommendations

Rate increases are a risk which professional investors need to consider in advance. We recommend taking specific measures to indemnify your investments.

How to invest in order not to lose money:

  • buy quality assets in locations where the population and income levels are growing. Unlike in the outskirts, in the central districts and those close to the centre, prices are falling less during recession and growing more quickly during market recovery
  • buy properties with long-term (10-20 year), fixed rental contracts. Such agreements allow smooth sailing through price adjustments
  • do not refinance the projects, but rather fix the rate.

What to do in order to earn:

  • find micro-locations which are going to gain in price quicker than their neighbours due to, for example, infrastructure and logistics improvement or gentrification. Prime examples of such neighbourhoods are Poblenou, Barcelona, Lichtenberg, Berlin and Wynwood, Miami
  • invest in the types of property that will most likely have at least a 10-year horizon (e.g. micro-apartments, hotels, warehouses and retirement homes)
  • invest in properties whose rental revenues and capitalisation rates will grow
  • invest in Value Added (development and redevelopment) projects – by doing so, you will benefit from the growth in price per m².

Experienced investors choose planning horizons of at least 10 years when putting their funds in rental property. As every real estate market is subject to cyclicality, price adjustment is unavoidable in the case of long-term investments.

However, in mature markets, the average yield rates and property price growth usually outpace inflation, thus offsetting future price adjustments.

In 2017, we recommend investing in foreign property based on the following criteria:

Macro-location A city whose labour market, population, and income levels are strengthening and growing
Micro-location A gentrified neighbourhood near the centre, in which the price growth will surpass the city average in the next decade
Property type Highly liquid properties, the demand for which will grow on a 10-year horizon, with above average revenue per m² (e.g. micro-apartments)
Financing 50-60% LTV mortgage loan at a rate fixed for the longest term possible

These recommendations will help to indemnify your investments against market correction risks if mortgage rates go up.

George Kachmazov, managing partner at Tranio.com

Originally published on inman.com

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