TL;DR: Interest rates have been historically low for the last decade. They are starting to creep back up. This could mean downward pricing pressure on property values. For investors to maintain current returns in this environment (assuming rents aren’t increasing), prices will need to drop between 6-10% for every 1% increase in the interest rate. This doesn’t mean you shouldn’t invest, but it does mean you should consider interest rate movements as you make your plans, whether as a buyer or a seller.
For the last decade, we’ve had historically low interest rates when compared to the previous 50 years:
Since 2012 rates have hovered between 3.5-4.5% for a 30-yr fixed mortgage. This is close to half the average since 1960:
Over the last 6 months interest rates have started to rise again, approaching 4.5%. The Fed has indicated this will likely continue, as they try to unwind quantitative easing and rein in an economy near full employment and at risk of over-heating. In this context, it begs the question, what this will mean for real estate investment property?
In general, rising interest rates tend to have a dampening effect on asset prices. This happens for two reasons:
- Opportunity cost / Return expectations – The expectations for future returns will be higher across all asset classes because investors can now get a slightly better return from a low risk bond. So on the margin, they should pay less today than they did yesterday for the same future stream of cash flows
- Borrowing costs – In addition, the cost of borrowing will increase, so assets that are leveraged will tend to be more sensitive to rising interest rates – real estate is definitely one of the most highly leveraged asset classes
So how will this affect the return profile of investment real estate? Well, the short answer is only time will tell, but what we can say is that one of a two things must be true. Either:
- Real estate prices will decline… or
- Returns will decline
What actually happens is really up to the complex interactions of every market, with investors, operators, and owners figuring out what they’re each willing to accept, given the current environment and their expectations for the future. But assuming the outlook for the future hasn’t changed in a meaningful way, let’s look at a few different scenarios of what could happen.
Hold property prices constant
What if we assume property prices remain flat from where they are today? What will rising interest rates do to returns? We can use a simple example to understand. Assume we have a single family home selling for $100K with a 7% net operating income (NOI – profit after all expenses before paying the mortgage), and a 75% loan-to-value (LTV) mortgage:
In this scenario, with a 4% interest rate on the $75K loan, you would make a 10.7% cash on cash (CoC) return. If you increase that interest rate 0.5% to 4.5%, CoC returns drop by more than 1%, down to 9.6%. If you continue increasing the interest rate, that relationship generally holds – for each 0.5% increase in interest rates, the expected CoC return from the property drops by ~1.1%. By the time interest rates are at 6%, CoC is down to 6.2%. In this case, expected investor returns would be declining in an environment with rising interest rates. This doesn’t make much sense, because you would think investors will demand a higher return as interest rates rise.
Hold Cash on Cash return constant
What if instead, we decided to hold the cash on cash return constant, and adjust the purchase price of the property to get to desired returns? In this case, we’ll aim for the same 10.65% return from the previous example. Now, as interest rates rise, the purchase price must drop to get to the same target 10.65% return. Going from 4% to 4.5% requires the purchase price to decline by ~3.7% to achieve the same cash return. This trend is pretty constant – for each 0.5% increase in interest rates, is would require property prices to fall ~3.5% in order to maintain the same CoC returns.
Increase cash on cash return with interest rates
But what if the higher interest rates prompt investors to demand higher returns from investment properties? What would that imply for property values? Well, if we take the above example one step further, instead of holding CoC returns constant, we will actually increase those returns (say by the same absolute change in interest rates). In this case, moving from 4% to 4.5% interest would move the target CoC from 10.65% to 11.15%. The impact would be that the property price would need to fall even further – this time dropping 5.3% due to the interest rate increase and CoC increase. This trend would be pretty constant, dropping the price by ~5% for every 0.5% increase in interest rates.
What does this all mean?
So this analysis is great, but what does it all mean? Well, first, you can begin to quantify the potential impact of rising interest rates on property prices. If rates rise by a few percent, it can translate into a real decline in property value. Of course, this doesn’t impact you if you already own and have long term financing in place. But it does impact you if you want to buy, or you want to sell.
Buyers: Make sure to take into account rising rates as you run your numbers, and look at historical comps. Reminding sellers that rates have already moved up and will likely continue could help you in negotiating prices down.
Sellers: Beware that property prices can flatline or fall even in the midst of an economic recovery. While an economic recovery usually comes with rising wages and greater ability to pay more for housing, it also brings rising interest rates, and often these forces will offset each other to some extent. One way to protect yourself is if you can get financing that can be assumed by a future buyer – this will give them access to the same great rates you have, but those terms are usually only available for larger commercial deals.
So… the Fed isn’t likely to jack rates a few percent over night, but over a few years we could see rates in the 5-7% range if things revert closer to historical norms. This can have a real impact on your investment returns, particularly if you’re looking to sell in the future.
Best of luck, and happy hunting!