Mortgage rates are going up. Some real estate investors might find that soon puts them in a very difficult financial position. How bad could it get? What do you do?
Interest rates can make a huge difference in the profitability of rental properties. According to BankRate.com, average mortgage rates rose half a percentage point from September to December 2016. That might not sound like much, but even small changes can be very expensive, and rates could rocket far higher than most imagine. Most analysts expect the Federal Reserve to keep pushing rates up for now, even if it is only to give them room to address a future recession. Of course, those who were in the business in the early 2000s know that rising rates were actually one of the big factors which forced the foreclosure crisis.
How High Will Rates Rise?
How high could mortgage rates go? As of early December, average 30-year mortgage rates were around 4%. That’s still crazy low. If you look at the data from the Federal Reserve Bank of St. Louis, we are still experiencing the lowest rates since 1971. That’s as far back as they are tracked. The average over the last 40 years has been around 7.5%.
So, let’s just say you have a $300,000 loan on a rental property at 3.5% (because you took it out a couple years ago). Your principal and interest payment would be $1,347.13 per month. Let’s say that with all other expenses totaled, you net about $200 each month in positive cash flow.
Now, if you need to refinance and rates are back up to that average of 7.5%, you’d end up with a payment of $2,097.64 each month. You’d be paying $750,51 cents more every month. You’d not only lose your positive cash flow; you’d have to find $550.51 from somewhere else each month just to break even. That’s hoping your tenant is paying on time and your property taxes or other costs haven’t risen as well. How many properties with $500 in negative cash flow each month can you afford to hold on to? If you made $5,000 per month from a day job, you would need all that and more just to keep afloat. This is exactly how the 2008 crisis happened. You can play around with this free mortgage calculator to see how the numbers would change for you based on different interest rates. I would definitely recommend checking out how much more you’ll actually pay for the property based on a higher interest to see those numbers too.
Finance Your Investments Right
The publicly traded REITs that utilize large amounts of leverage, as well as those investors buying on low cap rates with interest only in their terms, oftentimes take a big hit when rates go up. This is why buying and financing right are crucial steps. Another big con in the last few years has been companies promoting investments with 5 or 10-year balloon mortgages. What happens if you have a balloon mortgage, ARM, or flexible line of credit on a property you actually plan to hold for 30 years or more — especially in an environment where rates can virtually only go up? Let’s just say you better have a lot of equity to ensure you can sell.
What can you do instead? Real estate is still a fabulous investment. That’s why the banks make these types of loans. But you could buy cheaper properties, pay cash or partner up, and not use debt. Or you could borrow less, maintain more equity, and take long-term fixed rates.
What if you already made the mistake? Refinance and lock in low long term loan rates now if you can make the numbers make sense. Or cash out and readjust your portfolio with new assets.
What are you doing to protect your investments against rising rates?
Let me know with a comment!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.