If you've been active in the real estate market over the last several years, you've watched with the rest of us as mortgage interest rates fell … and then fell some more …. and then just when they were about to rise … they fell even more. Who would have imagined mortgages as low as 3% just a few years ago?
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It’s been phenomenal for buy and hold real estate investors who have been able to achieve fantastic cash on cash returns with such favorable financing. Wouldn't it be great if we could all just sit back and plan on low purchase prices and low interest rates for years and years to come? It certainly would, but I definitely wouldn't bet on it. In fact, in just one year, we've seen real estate values make major strides towards pre-recession prices. And what I would argue is equally notable, interest rates look to be on the rise as well. In fact, the chief executive at JP Morgan Chase was recently quoted as saying "I think you all should be ready, because rates are going to go up."
What’s the Impact
Many investors are watching rising real estate values with a sense of urgency to purchase while the deals are still good. However, I would argue that while increasing prices are definitely a motivating factor, rising interest rates are just as, if not more important to watch. Interest rates are definitely less predictable than rising values and can move in either direction much quicker as well. As we all witnessed just this last month, any minor shifts in policy or market demand can have a tremendous affect on mortgage interest rates and can affect future returns on an investment on a moments notice.
For example, let's say you are getting a loan on an investment property for $100,000 at 4% interest (assuming 20% down on a purchase price of $125,000). Your principle and interest payment is going to be $477 and for the sake of this example, let's say you anticipate monthly cash flow of around $300/mo.
Now what if you wait a few months to buy this property and interest rates jump a full point to 5%. Your principle and interest payment goes up to $536 a month – an increase of almost $60/mo. Your monthly cash flow now decreases to $240/mo. Do you realize that your monthly cash flow decreased by 20% as a result of your interest rate going up by a single percentage point?!
Strictly analyzing this from a cash flow perspective, that 1% increase in interest rate is actually the equivalent of that property increasing in value by $15,625 dollars! That’s right, if the property were to increase in price to $140,625 and you were able to get a loan for $112,500 at 4% (again, assuming 20% down on a purchase price of $140,625), your principle and interest payment would actually be the same as the $100,000 loan at 5% interest.
Bottom line – in terms of cash flow, that 1% increase in interest rate represents a difference in value of $15,625 dollars in this example! It also represents a 20% decrease in monthly returns.
I don’t know about you, but I’ve never been more motivated to finance properties before this incredible ride comes to an end. We all know that our economy can’t sustain these low interest rates for much longer. It wasn’t that long ago that investors were getting loans in the 6 and 7% range … and my guess is that’s where we will find ourselves in the not too distant future. I think investors would be well advised to take advantage of financing in the sub 5% range while we still have an opportunity.
Photo: Werner Kunz