We are seeing the end of a 22-year period of mostly falling interest rates that began in 1982. Except for the early 1990s, that period has been favorable for real estate, especially during the past few years when interest rates reached unusually low levels. Freddie Mac's measure of fixed 30-year rates dropped from 16.6% in 1981 to 5.8% in 2003; adjustable rates fell from 11.5% in 1984 to 3.8% in 2003.

Now we begin a period in which interest rates are going to rise for several years. Then they may either stabilize or rise more depending on what happens with general economic conditions. This shift in the economic climate will have important effects.

Tracking the Oversupply of Capital

The most recent result of declining interest rates has been a flood of financial capital into real estate markets. That influx has occurred for a variety of reasons: a flight from the stock market after stock prices plunged in 2000; investors' search for decent yields after returns from non-real estate assets fell to record lows; the carry trade of investors borrowing short-term capital at low rates and reinvesting it in real properties, especially REITs; and longer-term investors highly leveraging purchases of real properties with funds borrowed at low short-term rates to produce high returns on equity.

The net result was large enough capital flows into real property markets to drive prices of both commercial and residential properties to very high levels, producing correspondingly low capitalization rates. This phenomenon has stimulated speculative investments in both income and residential real estate markets.

Winds of Change

But things are now going to be different — at least over the next year and probably much longer. The Federal Reserve has begun worrying about rising inflation instead of incipient deflation because the Consumer Price Index has crept upward. Hence, the Fed has begun raising short-term interest rates in hopes of counteracting inflation.

As this tendency proceeds, it will soon reverse the recent slide in capitalization rates that link the prices of real properties with their cash flows. This fundamental change in underlying monetary conditions will gradually produce the following significant effects in real property markets.

  1. Commercial property prices will stop rising and probably will begin declining. True, cap rates will not rise as fast as short-term interest rates, and possibly more slowly than long-term rates. Also, the negative impact of rising cap rates will be partly offset by improving occupancies and rents as the economy expands.

    Moreover, most commercial properties today are owned by investors with large equities therein. So there is not likely to be a massive wave of defaults and bankruptcies like that of the early 1990s, when owners had much higher debt levels. Yet declining property prices will at least reduce the attractiveness of owning real estate.

  2. Some capital will shift out of real estate into other uses, especially into commercial lending as business firms borrow more to finance their growing prosperity. This will diminish the overhang of capital in real property markets, though that overhang will not disappear entirely.

  3. In homeownership markets, new construction and sales of existing units will decline, and price appreciation will slow or stop. Higher rates will make it harder for households to buy homes. That will reduce the number of households shifting from renting to ownership, thereby slashing sales of both new and existing homes — and increasing demand for rental apartments.

  4. Residential mortgage lending will sharply decline, especially refinancing. That likelihood coupled with consolidation will shrink the number of firms in the mortgage lending industry, which has enjoyed exceptionally high levels of activity in the past few years.

  5. Some residential condominium markets where prices have soared will experience plunging prices and more defaults. True, the underlying long-term market for condos near downtowns has expanded due to the growing presence of empty nesters and households opting to postpone childbearing. But huge price increases that have stimulated massive speculative buying in condo markets such as South Florida and Las Vegas could easily “burst the condo bubble” under the impact of rising rates and declining demand for homeownership.

  6. Except for a localized bursting of the condo bubble, these changes will occur gradually, not in a dramatic collapse of prices or activity levels. True, some market inefficiencies will occur, enabling opportunity investors to make deals. But conditions in real estate markets eventually will arrive at a new point of stability concerning interest rates, levels of activity and prices.



When that occurs, more emphasis will be placed on real estate market factors, rather than the main financial factors that have so greatly influenced market conditions during a period of huge capital oversupply.

Anthony Downs is a senior fellow at the Brookings Institution in Washington, D.C. He can be reached at anthonydowns@csi.com.