Over my property career I’ve observed that the impact of rising interest rates may well be greatest before they’ve actually risen. By that I mean that when headlines start suggesting that rates might rise, buyers start knee-jerking. What happens to property when interest rates rise? Well it usually means price growth slows but it doesn’t always mean prices fall.
Buyers often misjudge the risks in buying property.
People assess the risk of buying property differently depending on market conditions, but usually they get it all wrong. When prices are rising, people think the risk is not being in the market – being left behind. This risk is real, but one common response is much riskier: overpaying for B and C grade properties.
What happens to property when interest rates rise, however, is the properties most likely to fall in price are those B and C graders. Now buyers think the biggest risk is in paying too much. This can lead to them failing to buy an A-grade property because they feel better about buying a bargain.
So you can see that the fear of paying too much in a falling market is a bit of a red herring. The real risk is in not buying the right property, or in not buying at all and missing out on an opportunity to buy without the frenzy. That opportunity was missed by many in 2018.
What’s important is ignoring the noise around rising interest rates and looking at each property for its individual risk. Consider what matters to you and what you need in a home or investment property.
How easy is it to find an A grade property?
Here’s the rub, A grade property is scarce, they’re located in desirable locations where there is always an undercurrent of demand. Generally these are established suburbs with a limited supply of new stock, and a high proportion of owner occupiers with a substantial equity to debt ratio.
Owners of A grade properties tend to be in a strong financial position, so they can choose when to sell. What happens to property when interest rates rise, or when there is any sort of downturn and prices start to fall, is that these sellers start saying, “well, the market isn’t that great at the moment, I’m just going to sit on my hands.”
When an A grade property hits the market, buyers will compete for it. This is why some auctions are competitive even when prices are falling across the board.
Conversely, the stock that’s compromised will sit on the market for much longer, usually until the asking price is attractive enough to tempt a bargain hunter into making an offer.
Who will be most impacted by rising interest rates?
First home buyers are the obvious group to feel the greatest impact of interest rate rises because they have the highest debt to equity ratio. Risky locations are those where there is a lot of debt, particularly with a large proportion of young families with only one income or one and a half incomes. Vulnerable locations are those where there is an over-supply of homogenous stock such as new subdivisions with house and land packages and new apartment complexes.
Another at-risk group are people who paid a lot of money at or near the market peak for compromised assets. This is where buying a B or C grade property can bite, particularly if circumstances change and owners need to sell within a short period of time. I was amazed at the amount of people in this boat in the last downturn.
If you have owned property for more than a decade, you’ll know what happens to property when interest rates rise. Cast your mind back, you must remember rates around 7%, maybe even into double digits – I sure can. And we survived. The market didn’t fall off a cliff.
In fact, many home owners have used this recent period of low rates to get themselves into a better financial position by paying down debt and increasing their buffers. They won’t be under pressure to sell if rates go up. And if prices fall, they’ll be well placed to upgrade.
When considering what happens to property when interest rates rise, it’s important to note that the impact will not be uniform. That’s why it’s critical to understand the importance of asset calibre, even if it’s your family home, and always focus on buying the right property.
If you’d like to listen to the full podcast episode, this one’s all about our annual Fool or Forecaster Report – the bank scorecard. How well did bank economists go when predicting the 2021 property market?