The 10-year Treasury note is at 2.68% in January 2019. This is up from a cyclical low of around 1.5% in mid-2012. Interest rates rise and fall in a cycle, and the upcoming rising trend will begin two-to-three decades of rising interest rates. This will dampen home price increases, as buyer purchasing power is continually reduced.
The average monthly 10-Year Treasury Note (T-Note) yield since 1900 is shown on the chart above. As demonstrated, interest rates on the 10-Year T-Note have shown an overall decline since 1980, following a rise from lows last reached in 1941. We can now see that 1940-1950 marked the beginning of what has become a 60-year rates cycle: approximately 30 years of rising rates, followed by 30 years of falling rates. This roughly mirrors the 60-year period prior to 1950, in which interest rates peaked in 1921.
Mortgage rates have historically moved in tandem with the 10-year T-note at a 1.4% spread. However, this 1.4% spread was elevated – at around 1.5-1.7% – for several years following 2012. A downward trend from this more elevated spread has recently emerged. The forward condition of excess mortgage funds and a weak demand for mortgage originations will likely keep the spread below 1.5% in 2018.
10-year T-notes will continue their long rise as we start 2019. The upcoming period of rising rates is likely to last for quite a long time – two or three decades. The last three cycles in bond market rates have been extremely regular. A 27-year downtrend in rates (1922-1949), followed by a 32-year uptrend (1949-1982) and another 31-year downtrend lasting to the present.
While the regularity of this pattern of 30-year passages should be considered coincidental (they very easily might have been forty years, or twenty), precedent establishes that bond market rate changes are much slower and more gradual than, say, changes in the stock market.
Interest rates in the modern day
The key lesson to remember in the upcoming years will be that real estate is most properly priced and held for its inherent rental value. Those who buy property for speculative gain, not rental income, will see as little success in gains from a flip as those who invested in the real estate market from 1950 to 1980, when mortgage rates moved slowly, steadily upward until they exceeded 18%.
The next peak in rates, whether or not they reach past heights, will likely take another 30 years to arrive.
Changing dynamics in the years ahead
In the last two decades, it was possible to purchase a parcel of real estate, vacant or improved, and take a profit, much greater than the rate of consumer inflation, merely by holding that parcel for a short period of time. This is no longer an option.
Prices may rise in narrowly defined locations enjoying a population density explosion, but most will be dampened by constantly rising interest rates which will keep prices from rising faster than the rate of core inflation.
Smart investors will look to purchase property in urban centers which have already begun to establish themselves as the most desirable abodes for the next generation of homeowners and tenants. In the long run, investors in real estate will need to increase their wealth, not by flipping their properties for profit, but by generating rental income over the course of long-term ownership.
Income property will be bought to be operated and managed for an annual net operating income, capitalizing at the rate proper going forward. In boom times, property owners were accustomed to capitalization rates (cap rates) of 6% or less. For upcoming years, 10% may be more normal.
Prudent property selection, careful research, forward looking capitalization rates and a long-term commitment to real estate ownership will be the keys to success in the new paradigm.