Busting the Myth: Why Interest Rate Changes Don't Affect Real Estate Prices The Way You Think They Do
Updated: 4 minutes ago
Contrary to conventional wisdom, real estate price changes aren't directly correlated to interest rate changes. This article takes a hard look at the historical data. And then a renowned researcher explains why practically everyone gets it wrong.
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Practically everyone believes that interest rates directly affect real estate prices.
And it just seems obvious that:
Whenever interest rates go up:
It's more expensive for new buyers to get a loan to buy real estate.
So demand goes down, and prices have to go down, too.
Whenever interest rates go down:
It's cheaper for new buyers to get a loan to buy real estate.
So demand goes up, and prices have to go up, too.
But if you look at the historical data, it shows the conventional wisdom is often wrong.
Let's roll the tape
In this article, we'll look at the historical performance of both commercial real estate (CRE) and residential real estate in comparison to both Federal Reserve interest rates and longer-term U.S. Treasury rates.
The commercial real estate data was taken from Co-Star and spans from 1996 to present. So to make the comparisons valid, this was used for the spans for all of the graphs. This period covers four business cycles and three recessions.
Feeling "Fed" up?
Here's a comparison of Fed interest rates versus CRE prices from 1996 to present.
Federal Reserve interest rates:
Graph:
Graph is taken directly from Federal Reserve (FRED) website. For easier comparison between the two graphs, I marked in yellow the periods where the Fed raised rates (rates went up) and I marked in blue the periods where the Fed lowered rates (rates went down).
Note: To do a valid comparison, both graphs must use the same "units." The FRED graphs are available in a plethora of units, but Costar's only unit is an index of 100 (based on December 2000). So FRED graphs also use that unit.
Co-star Commercial Repeat Sale Index
Graph:
Graph is taken from Co-star website download. This is for the major real estate asset classes: multifamily, retail, industrial, and office. And again I marked in yellow the periods where the Fed raised rates (rates went up) and used blue for periods where the Fed lowered rates (rates went down).
So, looking at both:
When Fed rates went up (yellow):
If the claim is true, then these should all show prices going down.
Instead, the results were: up, up, up, down (with retail flat). So most of the time it actually went the opposite of the common narrative!
When Fed rates went down (blue)
If the claim is true, then these should all show prices going up.
Instead the results were: up, down, up (with retail flat).
So the common wisdom is wrong (and CRE prices changes are not directly correlated to Fed interest rate changes).
Score so far: Common-wisdom: 0. Unconventional-wisdom: 1
Sailing around U.S. Treasury Island
"Hold on", you may be thinking.
"That's plausible for the Fed. But CRE borrowing is usually based on longer-term U.S. Treasury rates. And the Fed has only indirect control of those (and those rates are generally set by the market). And everyone knows that changes in longer-term U.S. Treasury rates directly change CRE prices."
That's definitely the conventional wisdom point of view.
But is it right?
10-year U.S treasury:
Graph:
Graph is taken directly from Federal Reserve (FRED) website. For easier comparison between the two graphs, I marked in yellow the periods where the Fed raised rates (rates went up) and I marked in blue the periods where the Fed lowered rates (rates went down).
Note: To do a valid comparison, both graphs must use the same "units." The FRED graphs are available in a plethora of units, but Costar's only unit is an index of 100 (based on December 2000). So FRED graphs also use that unit.
This data is more volatile than the federal funds data, and there are sections where different people will interpret it as "up" or "down." For example, 2003-2006 was "slightly up" when all was said and done, and so some people would consider this an "up." But others would argue that rates went up and down repeatedly in that timeframe and claim this is not correct. So... to avoid getting distracted by this issue, I didn't mark up those areas and I confined the markups to more straightforward areas (i.e., where I felt 85%+ of people would agree that they are either an "up" or a "down").
Co-star Commercial Repeat Sale Index.
Graph:
Graph is taken from Co-star website download. This is for the major real estate asset classes: multifamily, retail, industrial and office. And again I marked in yellow the periods where rates went up, and used blue for periods where rates went down.
So if conventional wisdom is right...
When 10-year Treasury rates went up (yellow):
If the claim is true, then these should all show prices going down.
Instead, the results were: up, up, up, up-down (and up-then-flat for retail).
When 10-year Treasury rates went down (blue):
If the claim is true, then these should all show prices going up.
The results were: up, up, up (and flat for retail).
Arguably, there was a bias in both situations for "up." Either way: the common wisdom is wrong on this (and CRE price changes are not directly correlated to 10-year Treasury changes).
Score so far: Common-wisdom: 0. Unconventional-wisdom: 2
Okay, But Surely Residential Real Estate Is Different. Right?
"Fine," you might be thinking. "That's commercial real estate. And while it's valued at $22.5 trillion dollars of the economy, residential real estate is the larger sibling (at $37.4 trillion dollars). And the pundit on the TV told me that Fed interest rate hikes (and drops) do directly change residential real estate prices."
Is that pundit correct? Let's see.
Federal Reserve interest rates:
Graph:
Graph is taken directly from Federal Reserve (FRED) website. For easier comparison between the two graphs, I marked in yellow the periods where the Fed raised rates (rates went up) and I marked in blue the periods where the Fed lowered rates (rates went down).
Note: To do a valid comparison, both graphs must use the same "units." The FRED graphs are available in a plethora of units, but Costar's only unit is an index of 100 (based on December 2000). So FRED graphs also use that unit.
S&P CoreLogic Case-Shiller U.S. National Home Price Index
Graph:
Graph is taken directly from the Federal Reserve website (FRED). This is a same-sales index for residential real estate/single-family homes. And again I marked in yellow for periods where the Fed raised rates (rates up) and used blue for periods where the Fed lowered rates (rates went down):
So:
Fed rates went up (yellow):
If the claim is true, then these should all show prices going down.
Instead, the results were: up, up, up and finally up-then-down-then-up.
Fed rates went down (blue)
If the claim is true, then these should all show prices going up.
Instead, the results were: up, down, up, up.
Arguably, the market bias for residential real-estate in both scenarios was for home prices to go up.
Either way, the conventional wisdom is clearly false (and home prices are not directly correlated to the Federal Reserve raising or lowering interest rates).
Score so far: Common-wisdom: 0. Unconventional-wisdom: 3
"Et tu, 30-year treasury?"
"Fine," you might be thinking.
"But most consumers in the U.S. get 30-year loans. And this is driven by the 30-year treasury interest rates and markets, and not directly controlled by the Fed. So surely the 30-year treasury and residential real estate prices are directly correlated."
Is this claim true or not?
30-year U.S treasury :
Graph:
Graph is taken directly from Federal Reserve (FRED) website. For easier comparison between the two graphs, I marked in yellow the periods where the Fed raised rates (rates went up) and I marked in blue the periods where the Fed lowered rates (rates went down).
Note: To do a valid comparison, both graphs must use the same "units." The FRED graphs are available in a plethora of units, but Costar's only unit is an index of 100 (based on December 2000). So FRED graphs also use that unit.
This data is MUCH more volatile than the federal funds data and 10-year treasuries, and there are sections where different people will interpret it as "up" or "down." For example, from mid 2006-2009, it ultimately moved way down, when looking at start to finish. So some would say that this is clearly a "down." Others would argue, "No, it's actually 5 moves: down, up, down, up, down." So... to avoid getting distracted by this issue, I didn't mark up those areas and confined the markups to more straightforward areas (i.e., where I felt 75%+ of people would agree that they are either an "up" or a "down").
S&P CoreLogic Case-Shiller U.S. National Home Price Index
Graph:
Graph is taken directly from the S&P CoreLogic Case-Shiller U.S. National Home Price Index. This is a same-sales index for residential real estate/single-family homes. And again I marked in yellow the periods where rates went up and used blue for periods where rates were down.
So:
Interest rates went up (yellow):
If the claim is true, then these should all show prices going down.
Instead, the results were: up, up, up-down-up.
Interest rates went down (blue)
If the claim is true, then these should all show prices going up
The results were: up, up, up, up.
A person might argue that there was a direct correlation when interest rates went down, but not up. However a true, direct correlation would require it to work in both directions (not just one).
Arguably, the market bias in both scenarios was simply for home prices to go up.
Either way, the claim would be false (and home prices changes are not directly correlated to the 30-year treasury rate changes).
Final score: Common-wisdom: 0. Unconventional-wisdom: 4
What does actually set real estate prices?
So if real estate price changes and interest rates aren't directly correlated, what is causing the changes?
MIT’s Dr. David Geltner has studied this topic extensively. Geltner's the author of the most widely cited book on commercial real estate ("Commercial Real Estate Analysis & Investments"). He also won U.S. Pension Real Estate Association’s prestigious Graaskamp Award for excellence and influence in real estate investment research.
And I interviewed him back in 2015, here: https://www.therealestatecrowdfundingreview.com/what-will-the-next-downturn-look-like.
And here's what he said. Note: I was asking him to explain why real estate prices aren't correlated to recessions. But in answering that, he also answered this question about interest rates as well:
“Commercial property, that is, income-producing property, the type of property that can serve as an investment asset class, reflects pricing in two markets: 1. The space market, where the occupancy and usage of built space is traded (aka, “rental market” or “leasing market”); 2. The property asset market, where the ownership of real property assets is traded (the investment market). [Ian's note: which is made up of U.S. and international buyers] The former, commercial space market, usually suffers during a macro-economic recession, for most types of property in most locations, that is, rents and/or occupancy falls, so net income falls (often somewhat lagging behind the recession, both in the drop and the recovery). But there can be some types of space markets that are income-inelastic, such as moderate-income apartment properties and grocery-anchored retail centers or bargain outlet centers, which do not fall, or not much, depending on the nature and depth or length of the recession. But more importantly, the other market that determines property prices, the property asset market, which is a branch of the international capital markets, may react more independently of U.S. macro-economic fundamentals. That is, money may flow to investment real estate assets even though current rental fundamentals have taken a downturn. This is especially true for “first tier” properties (well-leased prime properties in prime markets, presently the “gateway six” being: Bos, NYC, DC, Chi, SF, LA), which may be perceived as a type of “safe harbor” investment. Capital may actually be relatively reallocated away from more risky or problematic asset classes (tech stocks in 2001, long-term bonds in 1981) and towards real estate. This can prevent property asset prices from falling, or from falling as much as they otherwise would. However, a lot depends on the nature of the recession and the financial system at the time, and also on the state of the space market. If the space market is severely over-built (excess physical supply), as it was in the late 1980s, then even a mild recession can be perceived as very bad news for commercial property, and that can scare the money away (perhaps rightly so, to some extent). Often it depends on how the equity capital reacts. The debt sources, being conservative, almost always shy away from commercial property in a recession (at least, the domestic sources of debt). But if there is sufficient equity capital (domestic &/or foreign) to temporarily take the place of the debt, then the overall property asset market can ride out the storm relatively well.
So, in summary:
Commercial real-estate pricing is driven by international capital markets and inflows/outflows.
This generally reacts independently to US macro-fundamentals (which includes US interest rates and US recessions).
Additionally, when interest rates rise, many other asset classes suffer worse than real estate does.
So when that happens, people will switch from them and buy more real estate.
This can cause prices to counter-intuitively rise (both on its own and/or by taking the place of debt).
And this counter-intuitive upward price movement can often be seen in the charts above.
Digging deeper / Learning More
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