Just to recap, Interest Rates represent the cost of borrowing money and are ultimately determined by three factors; the Federal Reserve, the US Treasury, and the banking industry.
Lowering interest rates encourage consumers and businesses to spend and invest which can result in a boost of asset prices. Raising interest rates makes credit less attractive and ultimately slows down the economy. The Fed’s goal is to keep rates at a healthy level that supports economic growth without letting the economy get ‘too hot’ or ‘too cold’.
During the COVID-19 Pandemic, the Fed reduced rates to nearly zero to help boost the economy and incentive growth. At the same time, the supply chain ultimately stopped which in-turn created a massive amount of demand. When supply cant keep up with demand, inflation increases. The Fed raises interest rates to help reduce inflation.
How do interest rates affect real estate
Raising interest rates impact capital flows which ultimately lead to an increased cost in development (Labor, Materials, etc.). This tends to slow down growth as developers may choose to hold off on developing while waiting for lending to ease.
There is some historical correlation between Cap Rates and Interest rates which is the Risk Premium which ultimately affects the value of real estate. Are they exactly correlated? No. But if interest rates rise, that could expand cap rates as investors demand to reduce their cost for yield.
A forward outlook
We are currently experiencing massive expansion due to the amount of demand and a lack of supply. If we are talking about residential, home buyers can lose 10% of their buying power for every 1% increase in rates. This might reduce the speed in home buying and could increase rental property demand.
There is no way to know what the future holds, but knowing the goal of the Federal Reserve, most likely Interest rates will continue to climb in the short term to reduce inflation which might expand cap rates enough for investors to reduce their cost of yield. But in the long term, we believe interest rates will ultimately come back down as supply and demand reach healthy levels.