How to Protect Your Real Estate Portfolio When Interest Rates Go Higher

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People tend to forget that what goes up eventually comes down. Similarly, low interest rates may have been satiating your investment appetite for some time, but eventually entropy prevails, and the economy usually rebounds.

The interesting thing is that most people try to pull money out of real estate as soon as they hear word of higher interest rates; little do they know that this isn’t always a negative sign. The general conception is that high and rising rates affect apartment building owners, commercial real estate, and offices.

Don’t follow the herd mentality and understand that rising rates aren’t exactly equivalent in magnitude to a zombie apocalypse. Imagine what that would do to the real estate market!

Related: DSCR: The Important Metric You Should Use to Gauge Investments

A cursory look at the current history indicates that interest rates don’t stay low forever; however, a major difficulty is faced in predicting the speed at which the rates rise. This obviously doesn’t mean that an investor should stop paying attention to interest rates, as that would mean investing with one hand tied behind your back. Not that you literally need both your hands to invest money, but hopefully you get the point.

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The Right Approach

The right approach involves asking the correct questions. For example, why are the rates rising? Different reasons may indicate differing scenarios or triggers, and while some may be disadvantageous to your situation, others can be beneficial as well.

A gradual increase in interest rates is not necessarily a bad thing, as it may indicate that the economy is recovering, and growth in economy means higher demand for real estate. As a result, land owners will be able to charge higher rents and maintain low vacancy rates, which should be a priority for all land owners, as they are crucial to maintaining a steady income and ensuring that a good rental yield is secured.

Refinancing

This is probably no secret and it may sound quite clichéd, but you need to be prudent when it comes to real estate investments. Thus, if you know that the interest rates are about to rise and you can refinance your property, do it. A good practice is to secure your mortgage at the current rates before they rise. It is also wise to pay off your loans and fix your credit score.

Debt Service Coverage Ratio

This is one of the main components of debt underwriting in corporate finance and is the amount of cash available to cover yearly interests and expenses. In personal finance on the other hand, it refers to the loan amount ratio loan officers use to determine how much a debtor can pay according to certain factors. It’s typically calculated by the formula:

DSCR = Net Operating Income/Debt Services

In which Net Operating Income is the net income, interest expense, cashable plus non cashable and amortization and depreciation. The Debt Services include the principal repayment, lease and interest payments.

Related: 5 Ways to Stay Afloat When an Eventual Real Estate Crash Happens

You can use the debt service coverage ratio as a guide to determine your maximum proceeds. Plus, the higher this ratio is, the easier it is to obtain a loan. As a rule of thumb, consider 1:30 as a debt service coverage. Since lenders typically use this to analyze the proceeds a certain property might be privy to, it has a large hand in determining the loan amount. In other words, you can easily calculate how much you can profit by using this coverage.

So stop conforming to the herd mentality, embrace your investor individuality, follow the advice and protect your portfolio value!

Investors: How do you react to rising interest rates?

Leave your comments below!

About Author

Ankit Duggal

Ankit Duggal(G+) is the Investment Director of a New Jersey Income Operating & Consulting Company . Ankit is a seasoned value investor who enjoys achieving a zen through surfing, hot yoga, and snowboarding.

4 Comments

    • Brian Larson

      Hey Andrey, let me see if this helps. This is a very basic calc and assumed you already have some calcs run for net operating income (NOI) and your debt service (princ+int portion of mortgage pmt).

      Since DSCR = NOI/Debt service you need to first figure out your NOI. Lets assume $1k rent/mo and 50% rule on expenses (I am making this very simple for illustration, don’t use this has hard and fast rule). This means your NOI is $500.

      Next you need debt service. Lets just assume you bought the house for $100k, 25% down and a 4% rate on 30yr term. You would have a debt service of $358/mo.

      Now you have both parts of the equation need for DSCR. $500/$358 = 1.40 (rounded up a hair). This is my bare minimum for buying a rental. I need a DSCR of 1.4 I order for me to purchase and this hits the mark.

      As Jesse says below, I think the blog should read 1.30 not 1:30 and I think this is a bare minimum. 1.4 will have you in a much better position long term and of course will keep the bank happy.

      I hope that helps. for another good article on the topic, see Ben L’s post from a few months back here: https://www.biggerpockets.com/renewsblog/2014/11/04/dscr-the-important-metric-you-should-use-to-gauge-investments/#comment-175278

  1. Presley Reeves

    Having lived through the double digit mortgage rates of the 70s I have a couple of thoughts. First, the Fed is in control until it is not. That means at some point the Fed may be reacting to market conditions, financial shock etc. They may not be able to execute a plan, but merely react to things out of their control. That means rapid increases in interest rates “a-la” Paul Volcker (federal funds rate of 20% in 1981). The beauty of real estate is that it is a real asset so it likely will be worth more than the dollars sitting in your bank. The bad news is, this will really hurt if you over leveraged and can’t service your debt.

    What to do. Don’t be over leveraged, and stay away from adjustable rates if possible. If you lock in these interests rates for twenty, twenty-five, or thirty years, you just might look like a genius ten or fifteen years from now.

    These historically low interest rates could linger for some time, or they could erase overnight. We just don’t know. Just being smart means that we need to have emergency cash, and keep any debt we take on small enough to withstand the market shocks that history has proven will come.

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