Interest Rates: A Critically Important Factor for Real Estate Investors
I just read an article today regarding the fact that mortgage interest rates have just reached their lowest point of 2011. Interestingly, I remember reading another article in early April of this year about the likelihood of rising interest rates and the urgency many real estate brokers were broadcasting to their clients to purchase before rates jumped higher. If anything, this serves as a great reminder that predictions about where interest rates are going are just that: predictions. These prognostications may be fairly accurate, way off the mark or completely wrong. At the same time, however, it’s important for real estate investors to understand how changes in mortgage interest rates can have a profound effect on their investments.
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I’m fairly confident that over the next couple of years the potential for rising interest rates will actually have more of an effect on real estate investments than the potential for recovering values (if values recover at all). As an aside, CoreLogic just released a report that presented a rather dramatic statistic: a whopping 25% of borrowers (that’s 1 in 4 are upside down on their mortgages and the default rates are predicted to rise. If this is true, I wouldn’t anticipate any significant recovery in foreclosure rates or real estate values in the near future. All this would certainly suggest that the window of opportunity to buy deeply discounted real estate will stay wide open for a few more years. However, even with continued low prices, real estate investments may not be as profitable in the coming years if interest rates climb.
For Example: Let’s say you buy an investment property today for $100,000, put 20% down and finance the other $80,000 with a 30 year fixed rate mortgage at 5.5%. In this scenario, you would have a monthly principle and interest payment of $454 dollars. Now, for the sake of this illustration, say you decided to wait until next year because you believed prices aren’t likely to increase in your area. Perhaps a year from now you are able to buy the same house for the same price, except now the interest rate has increased 1 point to 6.5%. At this interest rate, the principle and interest on a 30 year fixed mortgage would now cost around $505 dollars a month.
This is approximately a $50 per month difference. Over the course of a year, this is $600 in additional interest. It may not seem like much, but this can have a significant impact on your ROI. Let’s say in this example you could cash flow $250 per month at the 5.5% interest rate versus $200 per month at the 6.5% interest rate. That’s essentially the difference between making 15% versus 12% cash on cash returns. (($250*12)/$20,000)=15%; (($200*12/$20,000) =12%). By waiting until interest rates had risen just one point, the cash on cash return dropped 3 percentage points.
Not to belabor the point, but let’s flip this same example and say that prices did rise in this area, but interest rates remained the same. Perhaps the investor ended up paying $110,000 for the house rather than $100,000, but was still able to get a 30 year fixed loan at 5.5%. In this scenario, the principle and interest payment on a loan amount of $88,000 ($110,000*.80) is $499. This is actually less than the monthly P&I payment on the $80,000 loan at 6.5% interest. From a cash flow perspective, it could be argued that the investor benefits more by paying an additional 10% for the property with the lower interest rate rather than getting the lower price and paying the slightly higher interest rate.
From my personal business perspective, I’d rather have the equity position than the slight increase in monthly cash flow. Regardless of your preference or business strategy, it is interesting, however, to see what a profound effect a single point change in the interest rate can have on your investment. While most investors don’t have the sophistication to time their investment acquisitions perfectly, watching overall trends and changes to mortgage interest rates is still an important component to successful real estate investing. Finding the right investments is definitely important, but executing the buy while interest rates are at their most favorable may be equally as important.