Understanding How “This Time is Different” to Make Great Investment Decisions – Week 3

The Cost of Normalization:

The formula that is used to value the stock of publicly traded companies has two leverage points, anticipated rate of inflation and interest rates. For this discussion, the easiest way to understand the formula is that if interest rates go up, stock prices go down. Bonds are similarly inversely affected by interest rates.

In the exact same manner real estate values are influenced by interest rates, in particular the mortgage rates. The higher an interest rate a borrower has to pay on a loan for a real estate investment, the higher the rate of return the investor wants to obtain on that real estate investment.

If the interest rate paid for the loan is higher than the rate of return on the real estate investment, that is called “negative leverage”. Obviously, it is a very dangerous position and it means someone made a very bad investment because they are losing money.

Perhaps the simplest way to illustrate the impact of interest rates on real estate values is to look at housing:

  1. If a potential home buyer can afford a $1,000 per month principle and interest payment and interest rates are 3.5% per annum for a 30-year fixed rate mortgage, then that borrower can borrow approximately $223,000.
  2. However, if the interest rate on the 30-year fixed rate loan becomes 6%, then that same borrower can only borrow about $160,000, about 25% less.
  3. The lower amount that the buyer can borrow means that their purchasing power relative to a home has been reduced by about 25%.
  4. This ignores a lot of factors, but it gives a very simple illustration of the impact of higher interest rates.

If a home buyer’s purchasing power is reduced, that takes some buyers out of the market thus slowing the market/economy and puts downward pressure on home prices. Does this sound familiar?

This impact of higher interest rates will be felt across the economy. The 2017 Tax Law is brilliantly designed to offset some of the impacts, but not all of them. I need to provide to you some more information before we have that discussion.