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Investors: Let’s Talk About Rising Interest Rates

Ben Leybovich
4 min read
Investors: Let’s Talk About Rising Interest Rates

I guess you’ve probably noticed that the stock market has been somewhat temperamental lately (to say the least). Now, I am not smart enough to provide you with some answers, but I have also been known to ask some good questions in the past. Still, I did not want to write this specific article—until this morning.

My wife, Patrisha, as some of you know, is an agent in Phoenix. So, I made a couple of reuben sandwiches this morning, and as we were enjoying them, I said to my wife, “I should write something for BiggerPockets. It’s been a while. Give me three topics to choose from.”

Like water out of the firehose, she said, “Write about the interest rates. People who could qualify for a mortgage last week, can’t today because of the change in rates.”

Wow! OK; this is something real. Let us ask some questions and see if anything about the current economic environment becomes any clearer to us.

Why Are Equities Declining?

We obviously have to start here—why is the stock market declining? By all accounts, including that of the Fed, the economy is doing well. Corporate incomes are up. Wages are on the rise. So why the decline?

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The Fed President, Janet Yellen, was asked, on her way out the door, whether markets are inflated. She answered that market valuations are a source of some concern.

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A Few Questions & Answers

Question: Is the market afraid of inflation?

Answer: Yes!

Question: Why is the market afraid of inflation?

Answer: Because the Fed’s tool of choice to combat inflationary pressure is the interest rate.

Question: So what’s the problem with the Fed raising interest rates?

Answer: Neither residential nor commercial-leveraged real estate can easily afford it. At least this is what I imagine the market is thinking—hence the reaction.

Coming Back to What Patrisha Said

She said, “People who could qualify for mortgages last week, can’t today.”

For those of you who are newer to BiggerPockets, there is such a thing as debt-to-income ratio (DTI), which measures the relationship of one’s income to one’s debt-service obligations. As per the secondary market guidelines, in order to qualify for a mortgage, a person’s DTI needs to fall within certain parameters.

The trouble is, the cost of this new home you want to buy is included in the DTI calculation. Should said cost of ownership go up, the income needs to go up as well in order to preserve the DTI relationship.

Well, guess what? The interest rates going up by 0.5 percent is not nothing for a lot of people. Same with 1 percent. And after you’ve paid off all of the monthly debt obligations to free up some dollars for the DTI, if you still fall short, there are only two things left to do: ask for a raise or buy a cheaper house. Not so savory options for the majority of folks who are committed to becoming homeowners. Thus, Patrisha is right. People who were barely qualifiable last week are now out of luck, because a .5 percent increase in their monthly mortgage payment will tip their DTI.

Good—They’ll Be Tenants!

This is what we like to think, isn’t it? This is why we are so bullish on multifamily. The coming inflation helped along by the recent tax reform is going to create lots of tenants for us landlords! Let’s buy apartments!

It is commonplace in the Phoenix MSA that apartments are being marketed by the big national brokers on a 5.5% cap rate basis. And we aren’t talking about class A either. In Yiddish, we have a word that describes this product—dreck. Look it up. 🙂

This is not California, by the way. This is Phoenix, AZ. And yes, Phoenix is growing like crazy, but how do you make cash flow at 5.5% cap? But that’s beside the point for now.

Desirability of Multifamily

I can’t help but to remind myself that regardless of what your strategy in multifamily is, fundamentally it is all teed-up on cash flow (which is income minus expenses). What do you think happens to the cash flow in the event that interest rate goes up?

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Capitalization rate is a measurement of market appetite as it relates to income-producing real estate. The hungrier the market is for yield, the more money the market will pay for said yield. Reason would tell us that higher interest rates will adversely impact desirability of income property. Should this happen, the capitalization rates will jump up, thereby deflating valuations unless the rents continue to climb.

This Is All Very Confusing

I told you in the beginning that I don’t have many answers, only questions. Good questions. Indeed, it seems logical that we shall experience inflation. As Yellen said, valuations are up. Fifteen dollars per hour is the new target for minimum wage. Rents are up. All of this seems to point toward inflation.

What’s the Fed going to do with the interest rates and how will it impact markets? According to my wife, we are already beginning to see some changes in the primary residence space. She’s not alone in her observations, as her colleagues also see their client’s qualifications at risk. Now, while it seems that as people struggle to purchase, they will have to rent instead. But higher interest rates on investments mortgages may cloud both the entrance and the exit for multifamily nonetheless.

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Coming Back to Stock Market

Markets are alive. They live, they breathe, they talk, and right now, as I am watching the equity market take a significant haircut, I can’t help but hearing the market say to the Fed, “We don’t like inflation, so fix it! But don’t touch those damned interest rates! Real markets can’t afford it.”

And the equity markets, seemingly conceding to the notion of being inflated, are voluntarily taking a haircut in order to drive this message home to the Fed.

I am not sure it’s working.

To Wrap Up

Are you a buyer in this market? Where is your thinking on inflation versus rising interest rates and cap rates? What is your acquisition criteria relative to cap rate, rent growth, and exit strategy?

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Let’s get this party started with some real conversation on what’s relevant today.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.