Low rates cannot last forever

Interest rates have been artificially low for a decade, making cheap debt the norm. With rises seemingly imminent, property lenders should take note but keep their cool.

In mid-September, Mark Carney, the governor of the Bank of England, gave a strong hint that an interest rate hike was on the cards in the coming months to counter the inflationary effects of Brexit.

This would be the first interest rate hike in the UK for a decade, hinting that the trend towards historically low rates could be turning. UK interest rates currently sit at 0.25 percent, having been cut last August in a post-referendum emergency measure.

Meanwhile, in the US, the Federal Reserve has started to raise interest rates, which are currently at 1.25 percent to 1.5 percent, with another increase expected this year and potentially three more in 2018.

This should not cause lenders to panic. The real estate market consensus is that there will not be an interest rate shock, but rather a gradual realignment over the next few years. Indeed, eurozone interest rates languish at zero with no immediate signs of an increase.

European real estate markets have benefitted from the backdrop of low rates during the recovery years, and the assumption is that rising rates mean property values fall. It is hard to envisage the market being shaken by a sudden series of hikes. However, Carney’s message should serve as a reminder that low rates cannot last forever. Lenders should brace themselves for when economic growth ramps up and it becomes the right time to normalise rates.

Interest rates and inflation in 2017. Source: Emerging Trends Europe survey 2017

With an eye to that, debt providers should be prudent when writing fixed-term property loans, as the cost of debt is most likely to be higher in the coming years, when the asset enters its “refinancing zone”. Borrowers wanting fixed-term financing, on the other hand, need to be able to improve their properties’ rental income, to comfortably service debt if interest rates jump.

Longer term, the biggest issue for lenders could be the impact that a sustained increase in rates has on the property investment market. When real estate lenders are forced to put up lending margins – and they will when rates normalise – the higher cost of debt will hit investor demand, forcing investors to reassess their strategies.

In the wider picture, just as investors have been shifting to alternative assets in the search for yield over the past decade, they might get out of investments hit by higher interest rates – and put their money to work in corporate bonds for a safer return.

Although rate hikes are on the horizon, real estate lending is not under imminent pressure. The current gap between interest rates and property yields is large and provides a significant cushion for lenders and borrowers, creating a comfortable situation which won’t change overnight.

Lenders should not be lulled into complacency or denial though. Exceptionally low rates can help to create bubbles, with industry players focusing just on returns and ignoring the effects of potential increases in financing costs.

Recent history has shown us the risks of indiscriminate property lending – let’s not forget them now, even when turbulence seems far away. This projected rate rise should serve as a reminder that the market has benefitted from a favourable rates environment for a long time, and that cannot reasonably be expected to continue for many years more.

Email the author: alicia.v@peimedia.com