The real estate sector is the largest asset class for every country’s economy. Therefore, the health of the real estate sector drives the health of the economy and also the stock market. 

The real estate sector is in turn driven by the interest rates that central banks control. Interest rates represent the rate at which a country’s central bank lends money to a commercial bank. A commercial bank then lends that money to retail or commercial consumers at a higher rate. If the loan is for purchasing the property, the rate is called the mortgage rate. 

A commercial bank may lend to the borrower at a fixed or variable rate. In a low-interest rate environment, the borrowers tend to borrow at a variable rate. In a higher interest rate environment, a fixed rate is preferred to avoid making additional payments as the mortgage rates are expected to go higher in the future.

Key Takeaways

The visualization displays the relationship between fixed-rate mortgages and S&P 500 index. The chart shows 5/1 Adjustable Rate Mortgage (ARM) average for the United States. A 5/1 ARM has a fixed rate for the first five years of the loan. The rate then becomes variable and adjusts every year for the remaining life of the term. For example, a 30-year 5/1 ARM has a fixed rate for the first five years and an adjustable rate for the remaining 25 years. 

Absolute/ linear and log scales are available to analyze the available series in a better manner.

Generally, in the absence of any housing supply constraints, higher interest or mortgage rates slows down the real estate sector as the buyers tend to defer their purchase plans.

A lower interest rate environment supports the real estate sector as more buyers are willing to take additional risks to purchase properties resulting in higher property prices.

Higher interest rates also negatively impact other asset classes like stocks. Higher interest rates imply a higher discount rate used in the Discounted Cash Flow (DCF) analysis for a company’s stock price. A DCF model allows one to ascertain the present value of an investment by discounting the expected future cash flows at a rate called the discount rate.

Higher interest rates imply higher discount rates, resulting in lower stock prices.