Interest rates play a key role in real estate valuation, shaping borrowing costs, market demand, and investor decisions. The sustained elevated interest rate environment of 2024, hovering around the 6 to 7%, presents significant challenges and opportunities for the real estate market as we move into 2025. This blog explores the complex relationship between interest rates and real estate valuation, examining its impact on markets and considering the broader economic implications.
Current Market Dynamics
The current high-interest rate environment, significantly above pre-2022 levels, has slowed down real estate activity throughout 2024. Rising mortgage costs have eroded affordability for many potential homebuyers across the nation, leading to a slowdown in real estate sales. This affordability crunch is compounded by rising home prices in many markets, as stated by Economist Alex Bentz on the California Legislature’s Nonpartisan Fiscal and Policy Advisor: “…when both mortgage rates and prices increase, there is a compounding effect on monthly home payments, as borrowers have to pay higher interest costs on higher loan amounts.” (California Housing Affordability Tracker (4th Quarter 2024) [EconTax Blog])
Many existing homeowners, locked into lower mortgage rates (the lock-in effect), are often reluctant to sell, further restricting housing inventory. This supply-demand imbalance can put upward pressure on real estate prices, even as demand weakens due to high financing costs. The potential for a significant correction in real estate property values exists if demand continues to wane.
Interest Rates and Valuation
The valuation of income-producing real estate is fundamentally linked to existing interest rates. Most often, higher interest rates drive up the capitalization rate (cap rate), a significant metric real estate investors use to value properties. The cap rate reflects the expected rate of return on a real estate investment. As borrowing costs rise, investors often demand higher returns to compensate for increased financing expenses, this leads to higher cap rates. Consequently, real estate property values tend to go down as investors adjust their expectations for future returns.
Broader Economic Implications
The real estate market’s sensitivity to interest rates has far-reaching economic impacts. A slowdown in housing can send waves through intertwined sectors, including construction, home improvement goods and services, and financial services. Significant declines in property values can create negative equity for many property owners, potentially impacting consumer confidence in the market and their willingness to spend money. Furthermore, the commercial real estate sector is also vulnerable to interest rate fluctuations, affecting investment decisions and development projects.
Uncertainty of Future Monetary Policy
With inflation still above the Federal Reserve’s 2% target, the trajectory of future monetary policy remains uncertain. Further interest rate increases in 2025 could exacerbate affordability challenges and potentially trigger more significant price corrections. Conversely, if inflation moderates and the Fed begins to lower rates, it could stimulate demand and support property values. Real estate investors must closely monitor these developments to make informed decisions.
Navigating the Market in 2025
Understanding the intricate relationship between interest rates and real estate valuation is paramount for navigating the market in 2025. The ongoing uncertainty surrounding inflation and monetary policy requires careful monitoring of these factors. Investors and property owners alike must be prepared for potential fluctuations in interest rates and their impact on property values, affordability, and market dynamics. A nuanced understanding of these interconnected forces will be essential to being successful in the real estate market in the coming year.
Heather Zeller
Heather Zeller, Vice President of Marketing at Veros Real Estate Solutions (Veros) and Valligent, brings over 25 years of expertise in marketing, product strategy, and corporate growth across financial services, real estate, and fintech. With a strong foundation in Marketing, Economics, and Business, she drives brand innovation and market leadership.
