Rising Interest Rates: Why Real Estate Investors Should Be Worrying?
The Fed has recently announced to raise interest rates. And, this is certainly not celebrated among Real estate investors and Buy to Let Landlords. If you are an investor yourself, you may understand that the rising interest rates will make borrowing more expensive and this will squeeze your margins even further.
Feeling worried about rising interest rates is instinctive. But worry no more. As an investor, you should learn the recourse rather than panicking about it. We have written this article to help you understand what impact the rising interest rates will have on you and how you can prepare for this rise?
How Much Interest Rates are Expected To Rise?
The Fed has raised its federal funds rate by a quarter point ranging from 0.25%-0.50% already (1). It is expected that the rates will further rise to 2% and will prevail up to 2.75% in the next year . After the 2008 crisis, there has been near zero interest rates for continuous 7 years.
With the above rates, you can expect the home mortgage rates for a 5/1 ARM can go up to 5.7% or higher. The rate for 30 yr Fixed Home Mortgage will go up to 6.25%.
Say, you have a 30 yr fixed home mortgage with 4.5%. Now with increased interest rates, at 5.7%, you will pay $580 on every $100,000 instead of $507 at 4.5%. You can now calculate the impact of this increased monthly mortgage payment. On average, an American homeowner will pay about $275 extra every month when median home prices in the US is about $374,000.
Considering the average budget of the US Household as $5111, this raise in interest will hike your monthly budget by 5% (2). But what does it mean for an investor or a buy to let landlord?
How Rising Interest Rates Will Impact Investors?
The rising interest rates will impact every investor. When interest rates rise, the supply of money in the economy becomes tight. Hence tapping the rising inflation. But what impact will it have on real estate investors?
a) Housing Market tends to Cool Down
In general, when the interest rates rise, the housing market cools down. It costs more to borrow money. And when borrowing is expensive, it will hurt people`s monthly budget. Many would-be homeowners may postpone their purchase in this regard.
From an investor’s viewpoint, the property will take longer to sell in the market compared to when the interest rates are lower.
The demand for homes on the market may slow down a bit considering higher rates. But it also depends a lot upon the supply. If the supply remains constricted due to the current scenarios in which there is a shortage of materials because of supply chain problems and the rising costs of building materials. It necessarily doesn’t mean the prices will go down even if interest rates go higher.
As an investor, you should keep a watch as different markets will perform differently. Some markets may see increased property rates where there is a demand but restricted supply. In our opinion, the cities that have an average median income of less than $70,000 might see a decline in demand.
According to a report by Reuters, this year home sales declined by 6.2% year on year compared to last year.”
b) Appreciation Slows Down
A lot of investors fancy appreciation. They buy properties and sell in a short span of time making good quick profits. You mostly see this when the housing market is hot and prices are increasing rapidly. But when the interest rates rise, the element of appreciation tends to slow down.
Considering the interest rate rise, the inventories take longer on the market to sell. In such a scenario, there will be a correction in some housing markets as well. The continuous upward price rally will take a hit and the appreciation will slow down.
As an investor, you should hold off from buying an investment property for appreciation’s sake until the prices settle out. Else, it can backfire as well.
c) Cash Flow May Take a Hit
When the interest rates rise, your cash flow from a property is likely to take a hit. As we mentioned above with the likely increase, you may be paying about $73 more on every $100,000 financed through a conventional home mortgage.
The rent you collect and the expenses you have to pay will mostly remain the same. But, the monthly mortgage payment will increase making a dent in your monthly cash flow. However, if we consider the fact that many would-be homeowners will be delaying the purchase. The rental demand is expected to rise. And if you own a buy to let property in a neighborhood with stable demand, you need not worry much.
Although, in these times, it is the real stress test for your rental property business. Whether your business can accommodate slightly higher monthly mortgage payments or not? This is why we stress investors to always do a stress test via the rental cash flow analysis before you invest in a property.
d) Cap Rates are Likely To Improve
When the interest rates rise, the cap rates are likely to improve due to downward pressure on property prices. The cap rate is a ratio of Net Operating Income to the Purchase Price of the property. And when property prices decrease, there will be a higher cap rate and it means a less risky investment.
Try to understand that, when the interest rate increases, the rate of property likely decreases due to the fact that now investors can afford less.
Say at a 4.5% interest rate on a $300,000 loan, you can afford a $1900 monthly mortgage. But if the interest rate rises by just 1%, you could then afford only a $290,000 loan. Assuming 80% LTV, you could have afforded a $375,000 property with 4.5% interest, and with 5.5%, you could only be able to afford a $362,500 property. To get the same return from the property you are paying more on a property, reducing the cap rate and making it a riskier investment.
Keep in mind that the cap rates will increase only if the prices of the properties go down. And it will be interesting to see what actually happens. Whether the housing market cools down due to rising interest rates or will it continue to rise due to other economical factors in place.
What Investors Can Do To Prepare For Rising Interest Rates?
Now that you have understood what the impact of rising interest rates will have on your real estate business. Be you are a fix n flip investor, a real estate developer, or a buy to hold investor, rising interest rates will have an effect on each of us. It is better to prepare for this interest raise and tweak our business accordingly.
a) Cut Down on Your Personal Debts
For an investor, it will be wise to cut down on your high-interest rate personal debts like credit card loans, personal loans, or short-term unsecured loans; wherever possible. Because when the interest rates rise, these loans will be more expensive to pay off causing a rather big dent in your monthly budget. You must create some breathing room in your monthly budget should the need arise during rising interest rates.
Cut down on high-interest rate debts and better use a HELOC (Home Equity Line Of Credit) should there be any emergency requirement of funds arise.
b) Improve Your Credit Score
Review your Credit Report and check all the things that are negatively impacting your credit score. A low credit score means lenders will charge you high-interest rates. Improving your credit score will help you in times when interest rates are high. You can always consider refinancing your mortgages for better rates if the need arises. However, be mindful of the costs associated with refinancing. And, it will be always wise if you don`t change your actual mortgage term when refinancing.
c) Sell-Off Non Performing Assets
When mortgage rates increase, it is sensible if you sell off your non-performing assets. An increased rate will further hurt your bottom line and you can get stuck with a non-performing asset. Review your complete real estate portfolio and other investment for whether your assets will be able to suffice the rise in the interest rate or not? And if you feel, increased rates may lead to negative cash flow, it is better to break ties with the non-performing asset.
d) Hold On to the Cash
When the interest rates rise, the cash investor is at an advantage. There will be so many great deals going to be available for you if you can spare the cash. So, if you have the cash available with you to make an outright purchase, wait for a little and let the market settle. There is a good chunk of deals about to come floating from the deep.
During rising interest rates, lending standards become tighter. Those investors who majorly rely on financing wipes out of the market due to tight margins. There are not a lot of buyers. Your cash can really buy you great deals at below-market prices.
Should You Consider Fixed Rate Mortgages During Rising Interest Rates?
In an economy where interest rates are rising, a fixed-rate mortgage appears to be a better idea. The fixed-rate mortgage comes with stability and you have a fixed amount to be paid every month. But is it better and should you really consider switching to a fixed-rate mortgage from an adjustable-rate mortgage?
You may have an advantage with a fixed-rate mortgage that the monthly mortgage payments do not increase even if the interest rates rise. But the matter of fact is that the rate of interest with FRM is always higher compared to ARM. Yes, you get the stability in your monthly budget with a fixed payment but that comes at a price. You will pay more in the long term and even larger monthly payments compared to an ARM.
The FRM doesn’t really make sense even if the interest rates are rising. There is no point in switching a good term ARM as the interest rates are never returning back to the 80s rate and not even to the 90s level. Interest Rates are going to remain in the single digits for decades to come now.
Markets never run along a straight line. They are designed to go up and down based on the economy. When the markets get hotter and inflation is at an all-time high, it needs to be corrected. And, the Fed by rising interest rates do exactly that. Yes, it may not be good news among investors. But the silver line is that rising interest rates are not all that bad and neither are they rising to extreme levels.
Rising Interest Rates help bring a correction of real estate prices in the market providing more stability and better affordability. For real estate investors, it’s time to hold on to performing assets and sell non-performing ones. Further, if you are a buy-to-let landlord, your rentals are expected to see a lot more demand, fewer vacancies, and improved cash flow.
What are your thoughts about the rising interest rates and as an investor how are you planning to accommodate these higher costs? Feel Free to share your thoughts in the comments section below. And if you liked this article, feel free to sign up for our weekly newsletter to stay connected and receive all the updated information on our website.