How the level of interest rates impacts the prices and value of assets has probably not been high on the topic list for discussion at most barbeques over this summer, however, there is an argument that they should be, due to the potentially greater effect on absolute return over the investment horizon.
Around the developed world, central banks have decreased interest rates in the hope this will provide a stimulus for economic growth and prosperity, since when money is cheap, folks will borrow and in Australia, folks have taken up the offering. This has led to people placing bets into the capital city residential property markets. The consequence of this has been the price appreciation of residential property in those markets which, unsurprisingly, always seems to be front and centre of discussion around the good ol’ BBQ.
Property prices have gone up, but how many people have mentioned that the value obtained by picking up a property at an elevated price has increased in the same proportion as the price paid for it? That perhaps depends on one’s perception of value, however, this demonstrates one-way low interest rates have affected asset prices.
In times like these, we need to remind ourselves that “if price is what you pay, then value is what you get.” Price is self-explanatory, the amount is advertised broadly and it forms the base on which your future return is calculated. Value, however, is what something is truly worth or what you get out of owning the thing you bought. It follows that in order to maximise the prospects of a return on an investment, you always want to pay a lower price than the value you will receive from owning that asset.
So, how do interest rates exert influence on assets?
Primarily this happens through the use of the present value calculation which is a valuation method applied to an asset to determine the intrinsic value of it. Essentially this calculation is used to come up with how much in today’s dollars is $10 worth in ten years. We don’t need to go into the mathematics of the calculation here however, we need to be aware that if interest rates are high, we can invest a lower amount of money today in order to obtain $10 in ten years. Conversely, if interest rates are low, we have to invest a higher amount today in order to obtain $10 in ten years’ time.
To put this another way, when interest rates are low, the present value of a future $10 is high. When interest rates are high, the present value of a future $10 is low. When coupling this mathematical concept with the fact many risk-averse investors have been pushed up the ‘risk curve’ in order to generate an income to support their lifestyle, you end up having asset prices elevated above their intrinsic value. This is great for an existing owner looking to sell…not so great for a buyer.
Always remember, the higher the price you pay, the potential for a lower overall return…which should mean interest rates becoming something worth talking about around the barbie.
Please note this article provides general advice only and has not taken your personal, business or financial circumstances into consideration. If you would like more tailored advice, please contact us today.