A conversation about investments will always, at some point, touch on the topic of interest rates and therefore we are looking at how changing interest rates impact various asset classes in this series of articles. Last week we considered the impact interest rates have on the bond market and this week we will take a closer look at the real estate market as well as the equity market.
Real Estate
Changes in interest rates can have a significant impact on the real estate market, as they affect the cost of borrowing and the affordability of homes. Here are some of the ways that changes in interest rates can impact the real estate market:
Mortgage Rates
Interest rates have a direct impact on mortgage rates, which are the rates that lenders, usually big banks, charge borrowers to finance the purchase of a home. When interest rates rise, mortgage rates also rise, which can make buying a home more expensive and reduce affordability. Conversely, when interest rates fall, mortgage rates also fall, which can make buying a home more affordable.
Demand for Homes
Changes in interest rates can also affect the demand for homes. When interest rates are low, it can stimulate demand for homes, as buyers are able to afford larger mortgages and pay less interest on their loans. This can lead to increased competition among buyers and potentially drive-up home prices. Conversely, when interest rates rise, it can reduce demand for homes, as buyers may be less able to afford larger mortgages and may opt to wait until rates are more favourable.
Investor Behaviour
Changes in interest rates can also affect investor behaviour in the real estate market. When interest rates are low, investors may be more likely to invest in real estate, as they can borrow money at a lower cost and potentially earn higher returns. This can increase competition for properties and drive-up prices. Conversely, when interest rates rise, investors may be less likely to invest in real estate, as borrowing costs are higher, and returns may be lower.
Refinancing Activity
Changes in interest rates can also affect refinancing activity in the real estate market. When interest rates fall, homeowners may be more likely to refinance their mortgages to take advantage of lower rates, which can reduce their monthly mortgage payments and increase their disposable income. This can stimulate spending and potentially boost the economy. Conversely, when interest rates rise, refinancing activity may decrease, which could reduce disposable income and potentially slow down the economy.
Equity Market
Equity represents ownership in a company and provides investors with potential capital gains and dividends. Changes in interest rates can impact the equity market in various ways, depending on the reasons for the change in interest rates and the specific characteristics of the equity market. Here are some of the most common ways that interest rate changes can affect equity prices.
Cost of Capital
Interest rates affect the cost of capital, which is the cost of borrowing money for companies to finance their operations and investment projects. When interest rates rise, the cost of borrowing increases, and companies may have to pay more to borrow money. This can reduce their profitability and potentially lead to lower share prices.
Discount Rates
Interest rates are also used as a discount rate in valuation models, such as discounted cash flow (DCF) analysis. A higher discount rate will lower the present value of future cash flows, which could lead to a lower valuation of the company and ultimately a lower share price.
Investor Behaviour
Changes in interest rates can affect investor behaviour. When interest rates rise, bonds and other fixed-income securities become more attractive, as they offer a higher yield. This can lead some investors to shift their investments from shares to bonds, which could put downward pressure on share prices and the equity market as a whole.
Economic Growth
Interest rates can also affect economic growth, which can in turn affect the equity market. When interest rates are low, it can stimulate borrowing and investment, which can boost economic growth and corporate profits, and potentially lead to higher share prices. Conversely, when interest rates rise, it can slow down borrowing and investment, which could lead to lower economic growth and lower share prices.
In next week’s article, we will consider the impact changing interest rates has on foreign investments and exchange rates as well as on saving accounts to conclude our understanding of the relationship between interest rates and asset classes.
