Will Cash Flowing Rentals Disappear When Interest Rates Increase?
Mansfield, TX · Member since 2013 · 207 posts · 26 votes
Will Cash Flowing Rentals Disappear When Interest Rates Increase?
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Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes
13yThere will be lots of moving parts when rates invevitably rise. I do think the Bernanke asset bubble will persist for at least 2-3 more years, but eventually the piper will be paid.
However, when rates rise, assuming it's measured and somewhat gradual, an increasing number of people will be unable to qualify for home loans, and will remain renters, or become renters. So this should increase tenant demand and cause rental income to outstrip property expenses and perhaps keep pace with higher interest costs.
Of course, it's a possibility that a Japan-style period of low rates and very slow economic growth could prevail. But in the U.S. it seems more likely that high inflation will be the end game. Rental property is generally considered to be an inflation hedge, but if we get hyper-inflation and a major devaluing of the dollar, with extremely high unemployment and a govt that can't stimulate anything or support massive public housing/Sec8 spending due to a huge portion of quickly-shrinking tax revenue being spent on servicing the massive federal debt... then frankly I don't know how property will perform.
26 Replies
- Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes13y
Rates definitely affect profitability. When I started buying rentals in 2008, NOO rates were almost 7%. When I graduated college and moved to Houston in 1982 OO rates were 15%. Deals that work at 4% won't work and 7% or 15%. But there will always be deals out there.
- Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes13y
There will be lots of moving parts when rates invevitably rise. I do think the Bernanke asset bubble will persist for at least 2-3 more years, but eventually the piper will be paid.
However, when rates rise, assuming it's measured and somewhat gradual, an increasing number of people will be unable to qualify for home loans, and will remain renters, or become renters. So this should increase tenant demand and cause rental income to outstrip property expenses and perhaps keep pace with higher interest costs.
Of course, it's a possibility that a Japan-style period of low rates and very slow economic growth could prevail. But in the U.S. it seems more likely that high inflation will be the end game. Rental property is generally considered to be an inflation hedge, but if we get hyper-inflation and a major devaluing of the dollar, with extremely high unemployment and a govt that can't stimulate anything or support massive public housing/Sec8 spending due to a huge portion of quickly-shrinking tax revenue being spent on servicing the massive federal debt... then frankly I don't know how property will perform.
- Mechanicsburg, PA · Member since 2013 · 3k+ posts · 2k+ votes13y
Bill Mitchell
I once heard that for every 1% increase in the mortgage interest rates that people are shut out from qualifying for mortgages.
I bought a property and wrote the contract that I would accept 16% interest. i was so relieved that when I settled interest rates had dropped to 15% fixed for 30 years. That does reek havoc with your monthly payments when you're paying 15% interest. This rate was from a very large national mortgage lender.
I hope that I never see rates like that again, however I would not bet on it.
The next property that I bought which was about 4 months later, was owned by a real estate broker, who had used this house as a rental. He owned the real estate company, and times were tough. About 50% of the agents dropped out of the business because they were not making any money. Properties were typically days on market over 1 year. For example the 15% property above was in perfect condition and had been professional repainted. It had been on the market over 1.5 years.
Anyway a mutual friend also a RE broker, brought me this deal with his friend who owned the rental house. I told the broker owner that there was no way that I could buy the property and get another bank mortgage at 15% or whatever.
He wanted about 1/3 down and said he would finance the rest for 3 years at 12% interest with a balloon amort 15 years.
After some back and forth, I settled on 1/3 down 9% interest and 15 year self amortizing no balloon. I figured that he needed the cash to keep his RE doors open.
People who didn't need to sell, either didn't sell, or took their properties off the market. People who needed to sell did something to make it work despite the high interest rates.
Originally posted by David Beard:
However, when rates rise, assuming it's measured and somewhat gradual, an increasing number of people will be unable to qualify for home loans, and will remain renters, or become renters. So this should increase tenant demand and cause rental income to outstrip property expenses and perhaps keep pace with higher interest costs.
It's hard to figure out. As you said, rates rise, less people are able to qualify for mortgages, so there is more demand for rentals. But then as the demand for homes to buy drops, then by the same token, house prices drop. But now more people can qualify for the cheaper houses, so the demand for houses to buy goes back up, and there is less demand for rentals, and rents go back down. It seems like as long as the rise in rates is fairly gradual and not too steep, then it seems like maybe everything balances out. Hopefully...and of course, who knows what happens if there is a sharper increase.
This stuff makes me wish I'd paid more attention in economics class when I was in college...
- Investor · Baltimore, MD · Member since 2008 · 17k+ posts · 13k+ votes13y
I don't think anyone has mentioned yet, higher rates are likely to come with higher inflation.
Higher inflation = higher rents. Of course higher inflation means higher expenses too. So how fast the inflation comes will be a factor.
- Mechanicsburg, PA · Member since 2013 · 3k+ posts · 2k+ votes13y
Ned Carey Harry M.
The speed of the increase in interest rate hikes and in subsequent inflation is a factor. However, the amount of the interest rate and inflation rate is a more important factor.
In an inflationary cycle not all components of the economy rise by the same inflation rate. The inflation rate most often quoted is an average. Some items have higher inflation rates, others lower inflation rates and some items even have deflationary rates. Right now energy, education and medical are increasing in prices more than the average. For example gasoline prices are double what they were 4 years ago. Rents on the other hand are NOT double what they were 4 years ago, at least in any area that I'm familiar with.
For many people there are not a lot of options when it comes to renting. However, there are people that renting is discretionary, like recent high school and college graduates, and other newly formed households. If the economy is bad, unemployment is up, interest rates are up and inflation is up, then there are people that will stay at home with their parents or other relatives. Some Newly married people will live with their parents. Renters will double up, 2 or 3 people will rent together rather than each renting their own private apartment, to save money.
So while the high interest rates will preclude millions from buying property, not all of those millions will be captured by the rental market. Its not a one for one conversion. For every "X" number of buyers shut out of the real estate market, only "X" number minus "Y" number will be converted to tenants.
And when interest rates for mortgages were 15% to 20%, rents did not increase very much if any. It was a stagnant period and for the most part rents stayed about the same. Besides been a reduced buying pool there was also a reduced renting pool at the same time. Of course the hit was felt more by people trying to sell their homes as there were few buyers, and homes sat on the market for long periods often a year or more. But rentals were no bonanza either, as rents were stagnant and renters were removing themselves from the rental pool by staying at home literally and doubling up.
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes13y
All good points, but I like Harry's comment, interest rates up, prices adjust down. There are usually enough sellers who are motivated or must sell, people buy on payment affordability. The comps drop in price and the market stagnates or slows, those who don't have to sell don't, they dig in.
When buying at very low rates, unless you have a long term fixed rate, you should be looking at your deal at about 10% IMO as rates will fluctuate over time, seems 10% is an average expected in many areas. :)
- Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes13y
Originally posted by Bill Gulley:
When buying at very low rates, unless you have a long term fixed rate, you should be looking at your deal at about 10% IMO as rates will fluctuate over time, seems 10% is an average expected in many areas. :)Yes, good point, Bill, these 5-year balloon notes that local banks prefer to make now have the potential to wreak havoc on your portfolio if you're loaded up on them. If at all possible, try to get an ARM loan that has maximum annual and lifetime rate increases (usually 5 to 6% over the initial rate for a lifetime cap). Then stress your returns assuming this higher rate, and verify that you're still cash flow positive in that worst-case scenario.
If we get very high rates and inflation, and it happens in a compact period of time, bank earnings/capital is going to come under a lot of pressure due to the way they structure their portfolios. Many local banks will get wobbly and will curtail lending. Many will fail. The balloon notes may be impossible to refinance even at the higher rates. And your property value may well have declined, meaning you might have to put up some money to bring the LTV back into line. I saw a number of folks with performing balloon loans that were told to take a hike by their banks in 2008 when the banks didn't want to renew their performing loan, and they lost their properties and equity.
Another point of healthy conservatism is to always assume zero NOI increases and market value appreciation in your initial purchase projections.
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes13y
This is a great discussion. With multifamily specifically the biggest concerns I am seeing and my clients are seeing is when the landlord is covering utilities.
I have seen utilities go off the charts in some places that have been putting off increases or infrastructure improvements for years. The utility costs rise over a point at which you can't increase the rents so your costs go up and profit goes down.
This is why seller paid utilities I would have to get the property ultra cheap if I could not convert and put on the tenant.
Another interesting component to this discussion is triple net properties. With those properties for corporate rentals and lease agreements the landlord does not pay any costs on a true NNN deal and you can get annual rent bumps in the primary term of 1.5 to 3 percent a year.
So your cap increases every year but you have no costs. Of course with anything you have to buy the right property and location and corporate tenant to hedge risk.
The market at least where I am at is definitely improving. I am helping a family member get a house. I do not do residential but they wanted me to do it. When we started looking prices were at 260k a few months ago but now are creeping to 280k asking with limited on the market.
A buyer surge has been pushed recently by FHA changing their loan structure. FHA used to charge .5 mortgage insurance. Do to almost 16 billion in losses FHA over the past year has upped the mortgage rate on new loans over and over again. Was at 1% beginning of the year and then 1.25% and it is supposed to jump again to 1.35% in April.
Also interest rates have gone from 3.4 to 3.7 in the last few months. Starting June if you do not have your case number in with FHA then all loans after that point you will be stuck with mortgage insurance for the life of the loan regardless of the future value or pay down of the property ! That's right you will have to eat the mortgage insurance forever unless you drop 20% down in the beginning. There was an article today that says the conventional market is heating up and will replace FHA soon when FHA prices themselves out of the market to try and recover their losses.
http://www.cnbc.com/id/100548913?__source=xfinity|mod&par=xfinity
History shows interest rate increases with price increases. Rental properties will become less profitable cash flow wise as prices increase but buyers will buy because prices are increasing much like today's stock market.
I have not heard any imperical evidence that higher rates result in lower home prices -- generally because home prices are a result of a combination of complex factors. There was a good article in the Atlantic a couple of years ago that looked at this issue:
http://www.theatlantic.com/business/archive/2011/07/how-rising-interest-rates-affect-home-prices/241504/
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes13y
Bill Mitchell I agree with Sam W. that while the prices do tend to depress in times of high interest, but nearly enough to maintain equalibrium relative to CF. For this reason, in the 70es when interest ratres were 18%, there were a lot of land-contracts going on.
This is the only reasonable way to do it. This is also why it is so important to pay attention to what the feds are doing relative to regulating owner-financing...
- Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes13y
Obviously, available and terms of financing is a huge driver of home affordability and demand. But there is bound to be a huge trickle-down effect where buyers simply ratchet down a price tier in terms of what they can afford to buy. The entry-level buyer may be pushed out of the market due to higher mtg rates, but the trickle-down should help buttress demand at higher pricing tiers. This is with gradually higher rates and unemployment levels remaining stable. It's the hyper-inflationary scenario and huge economic dislocation, with high unemployment, that is most disturbing. That will no doubt lead to large shrinkage in total households as people consolidate.
Joel's points on FHA financing are interesting, since FHA is insuring the majority of new loans currently. It's amazing how expensive the portion of an FHA loan above 80% LTV truly is. To go from 80% to 96.5% LTV, a borrower pays an additional 1.25 - 1.35% for MIP on their entire loan, PLUS a 1.75% up-front fee. Break it all down, and it equates to an 11% interest rate on that "2nd mortgage portion" of the loan above 80%. Pretty nasty, imagine what it would be if nominal mortgage rate jump by 5%.
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes13y
In regards to private financing a bunch of banks have caught onto this from decades of experience.
They started adding power of sale clauses into all mortgage documents and putting in many reasons for being able to call the loan due.
Right now owner financing with wraps etc. is working because the banks are working through crud unless they are a new bank or they were one of the very few who made mostly all good loans and were conservative.
The VP's at some of the banks have told me on the phone as soon as rates start rising significantly and properties tart to recover and they have worked through most of the non-performing stuff then they will actively search for these owner finance arrangements and call all the notes due.
They want to relend the money at higher rates and only do shorter term loans for many products in a rising interest market. So if you are involved in owner financed deals just make sure to have an exit plan in place and budget for refi, sell, and the higher debt service that will most likely occur.
If the seller is financing the whole thing without an underlying mortgage or liens then you have less to worry about.
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes13y
It's pretty simple in reality, rates increase makes it harder to sell, to sell the price is lowered, at some point with a lower price it sells. That sale becomes a comp for other sales, I have not seen any data on it either, just lived through it and made loans during these periods with higher rates. People buy what they can afford, higher rates, less house. As rates drop, sellers ask more as well, they sell the house at a payment level more than a total sale price, it's a constantly moving target.
Joel, I'd suggest you start getting your clients away from multis where the owner pays utilities, it won't be long before utilities are higher than rents, watch and see what your energy companies are up to.....
- Investor · Lawrence, MA · Member since 2011 · 41 posts · 22 votes13y
We are seeing multifamily deals in the Boston market being purchased at sub 4% cap which is crazy. Because there is such lack of supply and huge demand here, people are overbidding on any decent property that comes to market, especially if its over 20 units. I think this could create another bubble, especially when rates come due and they are back to 6% or higher. I am being very careful right now in my deal selection. We just purchased a 12 unit in our area (Lawrence, MA) at 13% cap and locked in rate at 4.25 for 7 years. It is more of a cash flow deal but nonetheless better than a 4 cap. I will continue to pursue off-market deals in the 9% cap or higher range. Its the only way to bet against future interest rates.
Maybe I'm misunderstanding something, but this is why I am very hesitant about sub2s or any other type of financing that will violate the due on sale clause. Sure everyone says that they've never seen banks call the a loan before, but what happens when interest rates double? Triple? It would almost seem foolish not to call the loan due.
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes13y
Bryce that is the point. Right now banks are dealing with regulators and non-performing crud on the books where they have to resolve these legacy loans.
When they get through most of that in the coming years and interest rates rise they will then shift their attention to calling these loans due as the property value is most likely higher and they can get higher interest rate money.
Right now if they are paying regardless of outside agreements many banks are ignoring all of that.... FOR NOW
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes13y
Yes Bill it is a huge concern to put the utility on the tenants and let them carry that burden if possible.
Rates are rising, prices are rising. Is there something different than that right now? Expect more of the same until it changes.
There is lots of room for both to move upward. Do you doubt this trend will continue?
In my mind, rather then rising rates, the greatest threat to favorable property valuation over the near-mid term is the large amount of cash coming into the real estate market. You've written about it on this thread and it has been discussed on others as well...particularly the institutional money (hedge funds, etc) that are now playing.
As interest rates rise, the instituational money will chase the higher returns elsewhere. Unfortunately, they will leave inflated valuations in their wake (which is their intent) and made it less profitable for the long-term REI.
Originally posted by Sam W.:
As interest rates rise, the instituational money will chase the higher returns elsewhere. Unfortunately, they will leave inflated valuations in their wake (which is their intent) and made it less profitable for the long-term REI.
I've been thinking the institutional money situation could result in a multifamily bubble bursting in the next 5-10 years creating a huge opportunity to buy large multifamilies as the institutions rush to chase higher returns elsewhere (or even avoid losses since their 4 CAPs will no longer cash flow).
Why do you think it will leave inflated valuations in the wake instead of a crash in value?
- Mansfield, TX · Member since 2013 · 207 posts · 26 votes13y
Originally posted by Ryan M.:
Rates don't seem to be a issue when you're paying cash....Some of us like to leverage a fair amount.
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