May 2002

For a number of years now, mortgage interest rates have been at historical lows in much of the Western World – in some cases at 40 year lows. The general consensus is that low interest rates are great for real estate, on the reasonable basis that low interest rates mean low mortgage interest payments, and therefore higher affordability. Indeed many investors determine what they can afford to buy not on the basis of the deposit that would be required, but rather on the basis of what the monthly mortgage interest bill would be. For all these reasons, low interest rates seem beneficial to real estate investors.

It goes without saying that mortgage interest rates, inflation, and capital growth are considered to move somewhat in unison. In other words, during periods of low inflation, we can reasonably expect interest rates to be low, and often capital growth rates are similarly low. Conversely, when inflation is high, prevailing interest rates are often also high, and capital growth can be high.

This brings me to an interesting observation… Back in the early 1990s, when the government of New Zealand determined that inflation should be capped by law at 2%, many people made comments to me along the lines of “Well, Dolf, with inflation capped at 2%, capital growth will be destroyed, so there will be no more growth in real estate, so how can you go on promoting real estate as a good investment?”

The inference was that to do well out of real estate, you were dependant on capital growth, and during times of low inflation with capital growth severely reigned in, significant capital growth would not be there, making real estate a lousy investment.

There are a lot of interesting aspects to this simplistic line of reasoning that we should consider.

Firstly, successful real estate investing is not dependant on capital growth. If you acquire sound real estate in areas for which there is good demand for such real estate (be it residential, commercial, industrial, hospitality, or specialist), then you should enjoy good positive cash flow, and such income still beats exchanging time for money. If you are positively geared, then any capital growth will just be a bonus, but you will thrive even if there is no capital growth.

Secondly, low inflation does not always mean low capital growth of real estate. If there is an increasing population, then notwithstanding a low inflationary environment, the burgeoning population will result in demand inflation and capital growth despite low inflation. A point in case would be the city of Auckland, where despite a decade of relatively low inflation, capital growth has surged ahead through demand inflation. Another example would be Germany, where despite periods of negative inflation (deflation), real estate values still increased.

Thirdly, and most interestingly, however, is the negative bias that many professions have against real estate. When inflation is high, and a law is passed to limit inflation to 2%, rather than discuss the moral right of a government to manipulate the economy to restrict inflation to 2% (one would have to ask what the cost of this restriction was in terms of money supply, productivity, exchange rate and interest rates), many seize on the opportunity to infer that with inflation capped at 2%, there will be no growth in real estate values, and therefore real estate will no longer be a good investment.

Now that inflation rates are widely predicted to rise, these same pundits are saying that real estate will no longer be as good an investment as it has been in the past, as affordability will decrease, and therefore capital growth will disappear.

In other words, when inflation is high (remember this tends to go hand in hand with high interest rates and high capital growth) but set to come down, the commentators suggest that real estate will no longer be a good investment, and when interest rates are low (remember this tends to go hand in hand with low inflation and low capital growth) but predicted to rise, the commentators are again suggesting that real estate will no longer be a good investment.

For heaven’s sake, you cannot have it both ways! These commentators are either very intent on running real estate down, or they don’t understand it at all and know that doom sells better than optimism.

The reality is that whether interest rates are high or low, as a property investor you can do exceedingly well. When interest rates are high, there tends to be high capital growth. Fewer people can afford (or think they can afford) to buy real estate, so there is less competition, and it is much easier to buy a property at a bargain price. Even if you buy it at market value, that value is likely to change rapidly as the market continues its inexorable rise.

Conversely, when interest rates are low, you have the opportunity to lock in on these low interest rates, thereby guaranteeing low mortgage outgoings for as long as you can fix the rate, which in the US is up to 40 years.

The truth is that I do not really care where interest rates are at, or where they are heading. When they are rising or high, I know we will have some delightful capital growth, and that I will have some great buying opportunities as many people will want to bail out of real estate that is still an excellent investment. When they are falling or low, I know that I can finance properties using ridiculously low interest rates – even the bargain properties that you can continue to find no matter what the economy is doing.

Don’t spend too much time analyzing the economy. There is such a thing as paralysis by analysis. Instead, remember that all over the world, banks want to lend you money so that you may buy real estate. The photo at the beginning of this newsletter was taken in Sydney, Australia, where house loans are being offered with zero establishment fees.

Successful Investing!

Dolf de Roos 2002