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Palos Verdes, CA. There is an old German saying “postponed but not nullified”. This is true for the Fed’s decision to keep its central bank rates unchanged in September and October. The Fed’s vote against hiking rates surprised everyone less than did the reasons why. It seems the bench line of the unemployment rate has been downgraded in favor of actual inflation. This approach has caused some uncertainty in the real estate markets for the following reasons: 1) The Fed always runs the risk of getting it wrong, as it might constitute either too early or too late a move. To minimize any adverse impact, they create frameworks with policy objectives that are linked to intermediate targets. This does not eliminate uncertainty, but it at least reduces it as to how the Fed will react to future events. This reaction function cannot, and should not be, cast in stone, as the links from intermediate targets to policy goals are themselves uncertain and subject to change. 2) The Fed’s mandate is to create maximum employment with stable prices, which they define as 2% inflation. Fed officials have argued that they can’t wait for actual inflation to breach the 2% level, given the long and variable lags from policy to prices. As a result, they have often indicated that they will look out for signals of future inflation, the first being the unemployment rate, and use this as the intermediate target for setting rates. According to economist Robert Stammers, interest rates, especially the rates on interbank exchanges have a profound effect on the value of income-producing real estate. Because the influence of interest rates on an individual's ability to purchase residential properties is so profound, many people incorrectly assume that the only deciding factor is in the mortgage rate. However, mortgage rates are a major factor for influencing property values. Because interest rates also affect capital flows, the supply and demand for capital and investors' required rates of return on investment, interest rates will drive property prices in a variety of ways. Economist Stammers go on to say to understand how government-influenced interest rates, capital flows and financing rates affect property values, you should have a basic understanding of the income approach to real estate values. The income approach provided by appraisers of income rental properties is the discounted cash flow analysis. In simple terms, the valuation starts by forecasting property income, which takes the form of anticipated rental income. Then, by taking all property-level costs, including the financing cost, the analyst arrives at the net operating income (NOI), or cash flow remaining after all operating expenses. By subtracting all capital costs, as well as any investment capital to maintain or repair the property and other non-property-specific expenses from NOI, the result is the net cash flow available to investors. By discounting the cash flow stream for a given investment period, the property value is determined. Demand for real estate is related to changes in affordability. The fewer people able to purchase homes, the greater the demand for rentals and vice versa. Another important factor affecting supply and demand is the availability and cost of mortgage money. Interest rates play an important role in determining demand. In the final analysis, w still believe that Fed action will take place during the coming winter season. ABOUT THE AUTHOR: Eugene E. Vollucci is the Director of The Center for Real Estate Studies, a real estate research institute. He is author of four best selling books and many articles on rental income investing, real estate and taxation. To learn more about the Center for Real Estate Studies and its educational resources, please visit us at http://www.calstatecompanies.com
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