Last week, the Federal Reserve cut its interbank lending rate, the Fed Funds Rate, another ? of 1 percentage point down to 1%. What effect this will have on housing and construction spending depends on the willingness of lending institutions and borrowers to take on risk.
Clearly, lower interest rates are good news for the short term borrower. Typically, short term rates are based on an underlying interest rate instrument such as the prime rate that moves similarly to the Fed Funds rate. For the professional carrying debt tied to a credit line, home equity line and credit cards, the interest rate reduction should make it less expensive for you to carry the debt.
Rate cuts often are good for the real estate market and construction. Of course, when money is cheaper to borrow, more borrowing will occur, leading to an increased investment into real estate and improvements. In this sense, real estate investment and construction should benefit from the cut in interest costs.
“Should” you ask? Here’s the rub. Although short term interest rates are the lowest they’ve been in years, mortgage rates have spiked higher. The average fixed 30 year mortgage rate jumped from 6.06% to 6.46% over the past week. Even in a period of historically low rates, this rise in longer term rates will slow borrowing and limit buying and construction spending.
To make matters worse, lenders continue to tighten lending standards by requiring the borrower to have higher credit ratings, less overall debt and higher amounts of capital in the investment. Of course with stricter lending standards, more stress is placed on an already stressed market, which tends to keep some borrowers on the sidelines and further suppress demand. For many of us, these standards were the norm in years past and we don’t feel they are some new draconian plan to stifle investment. Recently, banks have simply been far too lax in their lending standards. This easy money, anything goes business practice, encouraged imprudent lending with borrowers becoming over-extended with unrealistic expectations on return and profit.
In general, prudent and reasonable lending standards are important to maintain a functioning marketplace. An overheated market with out of control price spikes or a frozen market with plunging prices, works against the long term investor and real estate professional. As developers, investors and contractors, we rely on some semblance of order in the market. The recent extreme price swings caused by speculators and interlopers, have made reliable valuation impossible.
In May, 2007 I wrote of the tightening credit standards of lending institutions and postulated that this tightening would lead to a softer real estate markets, business failures and a higher rate of foreclosures. In 2007 as with now, there was plenty of liquidity in the system, however lending companies were not willing to lend, even to qualified borrowers. Lenders were tightening as a reaction to a slowing real estate market and to meet the higher capital reserves requirements to protect against losses.
Today’s lower interest rates will not make a significant difference in the real estate market if lenders fail to make loans and invest in their communities. In order to “unfreeze” the real estate and construction markets, banks and borrowers need to have confidence their investments will hold value. In the end, the real estate and construction markets will get back on track as long as borrowers and lenders employ pragmatic strategies, invest in appropriately valued properties and use reasonable pro forma data on expected costs, growth and profit. Gone are the “get rich quick” schemes, at least for now.