REAL ESTATE MARKETS framework a) How would the asset/property framework explain
ID: 1162617 • Letter: R
Question
REAL ESTATE MARKETS framework
a) How would the asset/property framework explain why a reduction in long-term mortgage rates has the opposite impact on residential market values than a reduction in short-term rates.
b) How would the asset/property framework explain why residential mortgage lending remained weak during the housing correction even though interest rates and home prices were more affordable with respect to household incomes than a generation ago in the United States.
c) Many expect interest rates to rise again this year and next year. Explain the impact on market values, rents, and construction. Include the role of linkages across markets in determining the combined impact on the sector. A diagram is not required, but you may find using one helpful.
Explanation / Answer
Interest rates, especially the rates on interbank exchanges and Treasury bills, have as profound an effect on the value of income-producing real estate as on any investment vehicle. Because their influence on an individual's ability to purchase residential properties (by increasing or decreasing the cost of mortgage capital) is so profound, many people incorrectly assume that the only deciding factor in real estate valuation is the current mortgage rate.
However, mortgage rates are only one interest-related factor 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 drive property prices in a variety of ways.
Mortgage borrowers can be individuals mortgaging their home or they can be businesses mortgaging commercial property (for example, their own business premises, residential property let to tenants, or an investment portfolio). The lender will typically be a financial institution, such as a bank, credit union or building society, depending on the country concerned, and the loan arrangements can be made either directly or indirectly through intermediaries. Features of mortgage loans such as the size of the loan, maturity of the loan, interest rate, method of paying off the loan, and other characteristics can vary considerably. The lender's rights over the secured property take priority over the borrower's other creditors, which means that if the borrower becomes bankrupt or insolvent, the other creditors will only be repaid the debts owed to them from a sale of the secured property if the mortgage lender is repaid in full first.
In many jurisdictions, it is normal for home purchases to be funded by a mortgage loan. Few individuals have enough savings or liquid funds to enable them to purchase property outright. In countries where the demand for home ownership is highest, strong domestic markets for mortgages have developed. Mortgages can either be funded through the banking sector (that is, through short-term deposits) or through the capital markets through a process called "securitization", which converts pools of mortgages into fungible bonds that can be sold to investors in small denominations
A housing bubble is a temporary event, but it can last for years. Usually, it’s driven by something outside the norm such as demand, speculation, high levels of investment — all of which can cause home prices to become unsustainable. It leads to limited supply versus an increase in demand. According to the International Monetary Fund (IMF), housing bubbles may be less frequent than equity bubbles, but they tend to be twice as long.
Traditionally, housing markets are not as prone to bubbles as other financial markets due to the large transaction and carrying costs associated with owning a house. However, a combination of very low-interest rates and a loosening of credit underwriting standards can bring borrowers into the market and fuel demand. A rise in interest rates and a tightening of credit standards can lessen demand, causing the housing bubble to burst.
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