Prices for real estate are still high. But how do interest rates and their development actually affect real estate prices? Dr. Eva Stumpfegger and Dr. Florian Bartholomae from Munich Business School explain the connection!
Despite the corona pandemic, the real estate market in Germany is still booming, with prices rising by 2.0% quarter-on-quarter in the 2nd quarter alone (for details see here). This continues the trend of rising real estate prices in Germany, which has been ongoing for more than 10 years, with (major) cities and regions with strong economies – especially the Munich area – being particularly affected.
The principle of supply and demand
In a market economy, supply and demand determine the price of a good: In times of scarce supply and high demand for real estate, only those interested parties who have a sufficiently high willingness to pay will have a chance. Conversely, real estate fetches lower prices with a large supply and few potential buyers. Economically speaking, the shorter market side prevails: short supply – high prices or short demand – low prices.
So far, so simple. Yet, how do the sellers and buyers know the value of property, i.e. how much they want to get for it at least or pay at most? Interest rates play an important role in this price determination.
The connection of real estate prices and interest rates simply explained
Real estate buyers who want to purchase an apartment or a house themselves usually start with a cash check: How high are the savings? How much is the income available for living? Most buyers do not have enough equity to pay for their property directly, which means they have to take out a loan from a bank. For this, a certain interest rate i must be paid annually.
Considering this interest rate, it is possible to determine the maximum amount of the loan if you want to spend a certain amount of money each year on interest. Even though it may seem more complicated at first glance, it is easier to assume that you can pay this amount forever, i.e. for the rest of eternity. This results in cash flows – the interest payments – that reach into infinity. If all payments were simply added up, this would of course be an infinite amount of money. However, we need to consider the time value of money, i.e that 110 euros in one year’s time are not worth as much as 110 euros today. Why? Well, we could invest 100 euros today , which, with an interest of 10%, would also pay us 110 euros next year. Thus, with an interest of 10%, 110 euros in a year’s time are worth as much as 100 euros today. Furthermore, according to the same considerations, 121 euros in two years are only worth 100 euros today (121 = 100 * 1.1 * 1.1) – this also means that payments today are worth less the further they are in the future. In our example, we would therefore hardly be interested in an interest payment in 1,000 years. This is called discounting: future payments are related to the present using the current market interest rate. Since these payments then all have the same reference value (today’s value), we can add them up. This sum is called the net present value (NPV) and gives us the value of a cash flow as of today.
Low interest rates = high real estate prices, high interest rates = low real estate prices?
The net present value of all interest payments can be interpreted as the maximum purchase price for a property. Let’s assume that we have 1,000 euros annually available for interest payments. The cash value of an infinite cash flow (a perpetuity) can be easily calculated using NPV = a/i. With an interest rate of i = 0.5% and a annual payment of a = 1,000 euros, this results in a present value of NPV = 1,000 euros/0.005 = 200,000 euros. For the available budget for interest payments, a buyer can effect interest payments on a loan of 200,000 euros.
If the interest rate is significantly higher, for example i = 2%, the same 1,000 euros in interest payments will reduce the amount significantly to NPV = 1,000 euros/0.02 = 50,000 euros. This means that the higher the interest rates, the less mortgage you can afford since the weight of future payments increases. Taking a look to the current situation, potential buyers can afford a significantly higher mortgage volume at the current very low interest rates than 20 years ago.
Since unemployment has fallen and incomes have risen, especially in economically strong regions, not only the denominator (interest rate) has fallen but also the numerator (amount available for interest payments) has risen. You can simply calculate that each increase in net income increases the possible loan amount proportionally.
However, the situation is different for investors who want to generate income from a property by letting it out. In this case, high purchase prices go hand in hand with a low return. For this purpose, we can also refer to the above example calculations and interpret them differently: the 1,000 euros would be the (net) rental income, the 0.5% or 2% would be the return expected by the investor and the cash values would correspond – as before – to the purchase price.
Why do investors accept such (historically) low returns? There is a simple explanation: Due to the level of interest rates, other investment opportunities that are considered safe, such as government bonds, also offer low returns – in this case, very long-term bonds even offer a negative return. In the absence of alternatives, high purchase prices are therefore accepted.
Of course, there are many other factors that influence the prices of real estate, but, as shown, the leverage effect of interest rates is enormous.
What do you think: What will happen if the interest rate level changes?
The authors are responsible for the content and form of the article.
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