Would Rising Interest Rates Lead To Lower Real Estate Prices In Luxembourg?

The Federal Reserve (FED) has raised the federal funds rate eight times over the last two years. And even though the chairs of the FED and of the European Central Bank (ECB) have announced that no increase is expected in 2019, what effects would an ECB interest rate increase have on real estate prices in Luxembourg? In order to answer this question, we will first have to look at what happened during past periods of rising interest rates in the US as well as in Europe and what is currently happening in the US, where interest rates have already been on the rise. Then, we will take the quirks and particularities of the Luxembourg real estate market into account to try to understand what an interest rate hike may represent.

The relationship between real estate prices and Central bank rates?

Often, rising interest rates are associated with lower real estate prices. The logic behind the inverse relationship is this: retail banks adjust their mortgage interest rates in accordance with Central Bank key interest rates. Consequently, when the Central Bank rate rises, real estate financing becomes more expensive, creating a lower demand and ultimately driving prices down.

Changes in interest rates also have an impact on the returns of other asset classes. Therefore, to keep a rate of return that is consistent with the inherent risk of real estate, prices may need to adjust. However, it is also very important to consider the specific economic factors driving Central Bank interest rate increases. The actions taken by the FED are a direct response to strong economic growth in the US, designed to prevent the economy from overheating. The European economy, with its slower but nevertheless existing growth is not immune to an interest rate increase by the ECB.

By examining periods where the FED increased interest rates due to a bullish economy, from December 1995 to April 1997 for instance, where the 10-year yield increased by 118 basis points, we can see that the effect on property values and total returns of real estate investments in the US was not negative. Quite the contrary: prices and returns increased by 10% over the same period.

In Europe, the same evolution can be observed, with real estate prices rising from 1999 to 2002, despite increasing interest rates. And despite recently increasing US interest rates and a general real estate market cool down, real estate prices in New York, San Francisco, Denver, Seattle and other big cities are still on the...