Will interest rates really hit 10%?

Deep down all property investors knew the low interest rates couldn’t last forever, though I must admit I really enjoyed the strong cashflow that the lower interest rates brought with them over the last year or so.

The Reserve Bank of Australia warned us that rates had to rise from “stimulatory levels” as our economy improved and now after five rate rises since October last year, rates are back to what the RBA calls “average” levels.

So what next? Will interest rates keep rising, and if so when and by how much? And how will this affect our property markets?

The clear message from the RBA in its recent statement of monetary policy is that interest rates are too low for the current underlying strength of the economy.

This means that borrowers are likely to be hit by at least two more rate rises before the end of the year and face the prospect of even more rises in 2011.

This is because the RBA forecasts inflation to be back up to 3% – the top of its target range – by 2012, as soaring commodity prices boost income and investment, pushing our economic growth up to 4% by the end of 2012.

Let’s face it… this implies that interest rates will need to rise significantly higher.

The RBA believes that despite the issues in Europe and the US the global economy will still remain strong and it is clearly more focused on local inflation pressures. This has many economists expecting the cash rate to reach at least 5% by the end of the year (another two or three rises) and 6% in 2011, suggesting that standard variable mortgage rates could move to at least 9% over the next 18 months.

Will rising interest rates stop our property markets from rising?

Well, obviously the RBA hopes they will, but it’s not as simple as that.

Think about it… last year interest rates fell six times and still our property markets faltered. Since last October interest rates increased five times, but property values have kept surging.

So there’s more to it than just interest rates isn’t there?

It’s really about supply and demand and remembers the majority of this comes from owner-occupiers and not investors.

In 2008 and early 2009, despite falling interest rates, people put off buying new homes because they were worried about job security and the possibility of a recession. Putting it simply, they were lacking in confidence.

This year our booming population (which is increasing by around 9,800 people each week) and a shortage of supply, means that despite rising interest rates home owners and investors are feeling confident enough to buy a new home or their next investment. And this will continue for some time yet.
What will eventually stop this property cycle?

Well, in the past it has been either rising interest, which eventually hit a tipping point, an oversupply of properties because of overzealous development, or a recession and its associated unemployment.

With the undersupply of property and the lack of new construction it won’t be an oversupply of properties that puts an end to this cycle and we are unlikely to fall back into recession over the next few years, so eventually it will be rising interest rates that brings this cycle to a halt.

When will this happen?

There are too many unknowns to predict this, but looking at the upturn and boom phase of the last three Australian property cycles, we most likely have another two or three years to go.

And the best is yet to come! Prices will keep moving upwards as long as the number of new dwellings being built lags behind the number of people who want to buy them.

Now I’m not suggesting that prices will continue rising at the pace they have – that is unsustainable – but overall property values should increase between 8% and 10% per annum for another year or two before the boom phase of the cycle where property prices shoot through the roof before it all ends.

Of course, these are just averages, meaning many suburbs will outperform these forecasts and others (particularly the lower priced suburbs and first home owner suburbs) will underperform.

In short, not all property investors will reap the rewards of the next phase of the property cycle because our rising interest rates and lowered affordability won’t affect everyone equally.

While first home owners who have recently purchased may be feeling some mortgage stress, many established home owners who have considerable equity in their homes and investors who bought awhile ago take comfort in the fact that their home or investment is increasing in value. And to be honest, most hope prices will continue rising.

Just think about it, the staggering house price boom is diving our cities into haves and have nots. Many investors who bought into our markets last year before prices started their relentless march north have become very wealthy, almost overnight.

But for a generation of young people, the great Australian dream looks like remaining just that – a dream. These hopeful homebuyers are now facing a triple whammy. The burden of higher home prices, requiring a higher deposit; the cost of higher rent making saving for a deposit even harder and the challenge of obtaining finance now that their serviceability has been reduced by higher interest rates.

Also, our higher interest rate environment will mean that fewer builders will be building the apartments we need to accommodate all these tenants of the future and rents will keep skyrocketing upwards.

By the way, I’ve discussed this issue of affordability in a previous blog – you can read it by clicking here.

The bottom line for investors is to expect interest rates to keep rising a few more percentage points over the next few years, but they should be comforted by the fact that this will occur because property values will keep rising.

So to win “the game” of property investment you have to budget for higher interest rates and own the right type of property. One that will remain in strong demand by owner occupiers (so it will increase in value) and by tenants (who will subsidise your higher mortgage payments).

Michael Yardney is the director of Metropole Property Investment Strategists, a best-selling author and one of Australia’s leading experts in wealth creation through property. For more information about Michael visit www.metropole.com.au and www.PropertyUpdate.com.au.