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Two basic categories of interest rates exist: long-term and short-term. They have entirely different purposes. From the point of view of a real estate owner, they must be distinguished from one another.

Fixed long-terms rates are compatible with the fundamentals of real estate ownership, an appreciable asset. Both long-term rates and real estate have a built-in hedge against inflation since the perceived rate of inflation for the next 10 to 30 years is figured into the pricing of both. Both a fixed rate loan and real estate have a present value (PV) based on a capitalization rate of the future income each generates and the future inflation that is to be covered by the rents and interest rates, including the implicit rent of the property occupied by the owner. Thus, both are said to reflect the anticipated rate of future inflation.

However, as long-term rates rise, so do capitalization rates. They rise for the same reason: fear of inflation and increasing demands on the supply of money. As long-term rates rise, the pricing of real estate acquisition drops by the same ratio, unless offset by a concurrent rise in rents. Conversely, as long-term rates decline, the pricing of real estate will begin to rise. It takes about 12 months for the impact of a rate change to trigger a reaction among brokers, agents, sellers, and buyers. Thus, approximately 12 months after a rise or fall in rates, prices will begin their converse movement.

Short-term rates are incompatible with real estate ownership since real estate is a collectible. The short-term rate is driven primarily by the Federal Reserve in its fight against either inflation or deflation in the prices of consumer goods, the epitome of short term depreciable assets. The rate charged is highly volatile and does not factor in the rate of inflation, nor is a change in short-term rates reflected in the pricing of long-term mortgage rates, real estate ownership, or rents.

Adjustable rate mortgage (ARM) loans, the standard bearer for dispensing short-term rates into real estate transactions, disregard the fundamentals of real estate ownership. While the nature of a variable rate of interest on a mortgage makes it easier to buy real estate, ARM loans make it more difficult to retain that real estate. Also, ARMs temporarily and artificially driving up real estate prices. ARM loans are a perfect fit for speculators since they have no intention of occupying, using, or retaining the property financed by the ARM. If the property does not flip soon, then the speculator exercises his “put option” built into the provisions of every trust deed to sell the property to the lender for the amount of the loan. The put option is more popularly known by its unkinder moniker: foreclosure.

The distinction between the long-term and short-term interest rates forces lenders wishing to engage in the mortgage market to make a bet on the future of inflation and demand for money. To make a fixed rate loan, lenders must set the rate they will continuously receive on a 30 year investment, no differently than the investor who sets his price when acquiring the ownership of real estate. However, lenders would rather not bet on the future like owners of real estate must do. To avoid the bet, lenders invented the ARM loan and got the US Treasury to authorize its use in 1982. By doing so, lenders were able to avoid the California regulations limiting the percentage swing in rates to 2.5%. At first, they ARM was called a topless mortgage as it seemed the ceiling was set so high as to be meaningless. Thus the loan was shunned. In time the ARM became more tightly defined as a RIPOFF (Reverse Interest and Principal for Optimum Fast Foreclosure) mortgage for its short-term effect on borrowers.

Watch the 10-Year Treasury rates. Historically, the fixed rate for home mortgages has had a margin (spread) of 1.4% above the 10 year rate. The margin is presently double that rate due to the repercussions of Wall Street meddling in the real estate market since 2001. The money is there for mortgage bankers to lend, but the rates charged to recover past losses on ARM loans will drive down the price buyers will pay for real estate they will occupy. Mortgage money for investors in income property usually run at rates just above the rates charged on home loans since the government grants no implicit guarantee for those types of loans.

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Copyright © 2012 by first tuesday Realty Publications, Inc. Readers are encouraged to reprint or distribute this information with credit given to the first tuesday Journal Online — P.O. Box 5707, Riverside, CA 92517.

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