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What will happen to the real estate market if mortgage rates rise?

In recent years, mortgage rates in Europe and the USA have fallen, dropping to a record low by 2017, while real estate prices have grown at an accelerated pace.

However, in 2015, the US Federal Reserve System (FRS) began to gradually increase the discount rate. Many assume that, following this rate, mortgage interest will begin to rise (both in the United States and in Europe), and this will put pressure on the value of real estate, as investors will expect a higher return on invested capital.

Is it really worth fearing price correction?

How mortgage rates have influenced the value of real estate
Since 2009, the United States and European countries have implemented a policy of cheap money to revitalize the economy.

As a result, over the past five years, an unprecedented phenomenon has occurred in the global economy: the value of money has dropped to almost zero, and in some countries to negative values.

Mortgage loans have become almost free. For example, according to the Statista website, from 2007 to 2016 mortgage rates in Germany decreased from 5.2 to 1.5%.

In 2017, a resident investor in Germany can buy an apartment at 80% at the expense of borrowed funds at 1% per annum, then lease it and receive a yield of 3-4% per year. The owner can pay the mortgage with the help of rental income and enjoy an annual increase in the value of the object by 2–5% depending on location. The cost of financing is significantly cheaper than rental rates.

Also, bank deposits have ceased to generate income and even become unprofitable, since most European banks charge customers for keeping money. People are forced to look for alternative capital allocation tools and increasingly choose real estate, as this is an understandable and reliable way of investing with relatively high returns.

All this led to a situation in which the owners of real estate assets do not want to sell the objects at a reasonable price: if investors “go to the cash pool”, then they will have to invest money into something again, and there are very few offers. If you put the funds received in a bank account, you will have to pay negative rates. This further narrows the number of offers on the market.

Real estate prices, mortgage rates and building permits in Germany
Low rates spurred demand for real estate, led to higher prices in stable markets and stopped the fall in prices in countries that were significantly affected by the 2008 crisis. According to Eurostat, from 2013 to 2016 real estate in Germany and Austria has risen by 20%, and some markets (for example, Berlin and Munich) have grown even more rapidly. During the same period, they reached the bottom and prices began to rise in Spain and Portugal. At the same time, the markets of Australia, Hungary, Ireland, Canada, Poland and the USA were actively growing.

Today’s real estate market in Europe can be characterized by such a metaphor: Germany is a bath, and water is capital. The bath is overflowing, and the water is poured over to secondary markets – Hungary, Ireland, Spain, Poland, Portugal and the Czech Republic.

On the other hand, low rates have raised and the proposal, since there is more capital for construction. Over the past six years, due to cheap mortgages, the world market has received a huge number of meters, which would never have been built if it were not so cheap financing cost. Developers would not undertake the implementation of many projects, and end customers would never have bought the built objects.

Will higher rates lead to lower prices?
Over the past couple of years, the situation on the lending market has begun to change. Since 2015, the Fed has raised the discount rate three times and, possibly, will do it twice more until the end of 2017 – in June and December.

Fed raises interest rates carefully. His task is to effectively balance the risks of low rates and the desire not to stop the growth of the economy.

From the discount rate depends on mortgage rates. And with the increase in interest in the United States may be followed by an increase in rates in the UK and continental Europe. And it is not known how the market will behave if the rates start rising.

If loan rates rise significantly, investors will lose purchasing power. Deposits will begin to bring back even the minimum, but the yield. Most likely, by this time the volume of construction has reached a peak, and the market will increase the supply of real estate: the owners will want to take profits or abandon the burdensome mortgage and objects that have lost liquidity.

All this can stop the aggressive growth of purchases and even cause a decline in real estate prices in peripheral locations.

For example, in the United States, the object brought the investor 5% per annum with a treasury yield of 1%. The spread (or risk compensation of the investor) was 4% per annum. Then the general level of interest rates increased, and the yield on Treasury bonds rose to 3%. It is logical that investors (potential buyers of this object) will demand the same compensation for risk as before.

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