More interest on Interest Rate

One of the important drivers for real estate value is interest rate. The other important drivers would be income/economic growth & demographic. When US interest rate (represented by 10-year Treasury Bond yield) dropped from a high of 15% from early 1980s to a low of 1.5% in early 2013, US real estate index rose from 60 points in 1985 to 200 points in 2006. See Chart 1 & 2 below.


Chart 1: TNX price chart as at June 11, 2013 (Source: Yahoo Finance)


Chart 2: US Real Estate Index as at June 11, 2013 (Source: aboutinflation.com)

While the above charts are based on the US example, I believe the same also applies to other countries, such as Malaysia. When I first started working in the banking industry in late 1980s, housing loan interest rate was above 10%. Over the years, interest rate has dropped steadily to a low of 5% recently.

If interest rate regime changes from a declining trend to a rising trend, I believe the value of real estate would be capped initially and then reversed. This topping-out process would not be immediate and may play out over a few years duration- depending on the movement in interest rate.

I remember one exercise that we did when I was in the bank when we raised the installment amount on the housing loan customers due to increase in interest rate (brought on by increase in Base Lending Rate). Many of the customers struggled to meet their installment payment. The reason we raised the installment amount was because the amount received was not enough to cover the interest accrued on the loan. For example, a RM500,000 housing loan on a tenor of 30 years at an interest rate of 6% would call for monthly installment of RM2698. If interest rate rises to 8%, the installment amount would rise by RM604 (or, 22%) to RM3302. That amount can be very taxing for many borrowers and especially so for over-leveraged borrowers.

In an environment where investing or speculating in properties has been a sure-thing for so long, the danger of a disorderly clearing out is very real. This danger had prompted a Singapore Minister to caution the citizens of the republic of the impact of future interest rate hikes (here). If you think this is another example of Singapore kiasu mentality, think again. Yesterday, Indonesia raised its interest rate by 25 basis points to 6% (here).