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Real Estate Bull market since March 2009
Real Estate has performed extremely well since it bottomed out after the financial crisis around the beginning of 2009. The S&P Developed Property Index in the chart below shows the constant rise in property prices since the index touched a low of 101.40 on March 09, 2009. This index is investable as it tracks REITs and REOCs which invest in residential, retail or healthcare properties.
The index reached its most recent low after having reached a high of 389.79 on February 22, 2007 which is equal to drop of 74% over the following 2 years. It may also be true that true prices for Real Estate had been exaggerated from the losses incurred by the REITs and REOCs making up the index.
This is because Reals Estate does not change hands as frequently as the shares of the funds that invest them. The shares are quoted on public exchanges and may have suffered from the sharp decline in the price of shares of the broader market.
However this index tells us when the market stopped its decline and how it has performed since. You can also see from the graph that the index has not reached its pre-crisis high, with a close of 389.79 on February 2007.
Current levels leave room for speculation that Real Estate can still accommodate higher prices as they have not yet reached pre-crisis levels, as have other assets such as Stocks and Bonds.
Higher interest rate regime on the horizon
It seems to be very likely that December’s Federal Reserve monetary policy meeting will produce the first in a series of interest rate hikes. There has been a lot of talk about it over the past several months as Chairwoman Yellen prepares the market for the event.
Going into 2016 we will probably see further hikes if the economy shows the job creation and inflation pressure that the Federal Reserve has been using as the main metrics for their change to a higher interest rate regime.
Higher interest rates are often considered as negative for house prices and Real Estate prices in general. The main reasoning is that higher interest rates means that mortgages to buy Real Estate will also be more expensive.
The effects of an interest rate increase on Real Estate prices can be easily seen. Let’s say you are considering buying a house valued at $600,000 with a $500,000 on a 20 year mortgage, an increase of ½% in the interest rate will mean you need a reduction of approximately 5% in the sale price to compensate for the extra cost of your mortgage.
What the facts say about higher interest rates and Real Estate prices
But there is also the other side of the coin to higher interest rates cutting Real Estate investors’ buying power. Higher interest rates come together with faster growth rates, higher levels of employment and a stronger consumption demand. These factors usually push prices up, including Real Estate prices.
Someone with higher levels of confidence and future prospects is also more likely to decide to sacrifice some disposable income now to pay for a more expensive mortgage. This means that in the above example the person may simply buy the house at the whole price of $600,000. In doing so they would simply off-set the greater expense now with the confidence that they will make more money in the near future.
Commercial properties may benefit from higher interest rates also. The lease contracts of most commercial and industrial properties are linked to inflation indexes. Usually periods of higher interest rates also go in parallel with periods of higher inflation.
Since the 1970s there have been six periods where interest rates in the US have increased. The table below shows six periods of increasing interest rates, as identified by the US 10 year treasury yield, with the returns for a REIT index and the S&P 500 index. In four of these six periods the REIT index had a positive return and in three of them it out-performed the Stock index.
Long, short or Hold
I think it is reasonable to expect to see Real Estate continue its course upwards over the next years. I say that as GDP is expected to continue its growth and job creation is healthy. These two factors usually produce a very buoyant economy which increases demand for most goods and assets. It should therefore have a positive effect on buyers of Real Estate. Real Estate has also been shown to be positively related to inflation, a factor that may put more upward pressure on prices in the coming years.
REITs are a great vehicle to invest in Real Estate as they have the liquidity of a publicly traded market and are tax efficient. They pay great dividends as 90% of revenue has to be paid to shareholders for REITs to keep their preferred tax status.
I would be cautious with Mortgage REITs as these funds, as the name suggests, invest primarily in Mortgages as opposed to actual property. Mortgages carry interest rate risk which when not hedged properly can cause these funds to underperform. This may be especially accentuated as we move into a higher interest rate regime.