Will higher interest rates curb another surge in European housing prices?
What is the relationship between housing prices, interest rates and inflation?
Residential investments today are providing a tangible cushion for investors, owner-occupiers and landlords alike. Even though housing prices are likely to be capped in a number of countries in the short term because of higher borrowing costs, we believe real estate values will continue to beat upcoming inflation levels. Beyond compare, attractive financing conditions (affordable monthly mortgage instalments, refinancing options) have been key drivers for value preservation in recent years. As a matter of fact, nominal interest rates are set to edge up in the medium term, which could change the mindset of investors. The key question is whether higher nominal interest rates will result from soaring inflation.
What is the relationship between housing prices, interest rates and inflation? Direct real estate (commercial and residential) may offer investors some protection against a sudden surge in inflation. If nominal interest rates rise because of a projected acceleration in demand inflation, then real interest rates (adjusted for inflation) will remain more or less stable. If a property owner finances his own “bricks and mortar” at a capped rate before inflation surges, borrowing costs will remain unchanged while rental revenues will increase. Protection against inflation is undeniably only partial for two main reasons: i) there is a time lag between the rise in prices and the rental indexation, often six months or more and ii) the various indices used for rental indexation do not always fully reflect future inflation. In the event of inflation, growth in rents tends to occur before values go up. Theoretically, property values could be considered as an infinite supply of growing rental cash flows, which is why rents rely on inflation to climb.
In the short term, higher nominal interest rates may spark temporary jitters in the housing market, with or without inflation. We believe this is likely to happen, with investors focusing solely on rising borrowing costs. Indeed, it may take a while before long-term investors can reap the benefits of the impact of inflation on housing values.
Apart from interest rates and inflation levels, other factors drive housing markets:
1. Usual economic circumstances
By “usual economic circumstances” we mean local supply and demand, employment levels, currency movements, political instability, etc. Actually, economic circumstances (or factors) may be considered as external factors. The principle of externalities is that real estate values may be affected by conditions which have nothing to do with property.
Spain is a good example of this. In 2008-2010, the country faced overproduction (falling demand coupled with oversupply) representing millions of properties, which resulted in a price slump (by 40% in some geographic locations).
Currency movements may eat into the returns of overseas investors, a notable example being Latin America (in particular Brazil).
2. Government policy and regulations
Under this category, we cite zoning, public transport links and other amenities, fiscal policies, availability of credit. Fiscal policy is key, in particular changes to the tax treatment of real estate. Several issues are at stake. For example, is stamp duty about to rise? What about capital gains tax in the event of a property sale? And inheritance tax? Are mortgage interest rate payments deductible from the taxable base, and if so to what extent? Could a government’s reduced mortgage tax relief measures push down housing prices?
The UK introduced a capital gains tax for all buyers which became effective on 1 April 2016 (only British citizens and residents were subject to CGT prior to this date). The amount of stamp duty for the purchase of a second residence was raised on the same occasion. Some Belgian regions (Flanders, Brussels, and Wallonia) have been reducing tax mortgage advantages since last year. Although there are numerous examples to illustrate this, it is essential to assess the fiscal impact on housing values. If a government allows almost unlimited tax deductions of interest charges, in a way it is “subsidising” swelling housing values, and the nation may become “over mortgaged”. This was the case in the Netherlands for decades. The system finally changed in 2013 with the introduction of some mild reforms (e.g. reducing tax relief).
3. Social factors
Social factors are the result of demographic changes. Today, there is a growing need for smaller housing units because the number of people living on their own is on the rise in many countries. At the same time, populations are ageing rapidly (Europe, Japan), thus creating the need for more “serviced” housing schemes. Moreover, there is often a lack of “affordable” housing (e.g. London). So the supply and demand of “products” will change over time, as will prices.