Mortgage Interest Rates Are Rising. Will They Crush Your Rental Portfolio?

by | BiggerPockets.com

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.

Related: 4 Popular Mortgage Programs for First-Time Home Buyers

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.

credit-report-loan

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.

Related: Recently Self-Employed? What You Should Know Before Applying for a New Mortgage

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.

cash-flow-rental

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!

About Author

Sterling White

Sterling White started in the real estate industry at a early age back in 2009. The company he co-founded Holdfolio is a real estate crowdfunding platform based in the Indianapolis market. Before founding Holdfolio Sterling and partner Jacob Blackett were involved in the purchasing and selling of 100+ single family homes nationwide. In his free-time he trains for a World Record.

20 Comments

  1. Sterling is absolutely correct….I try too advise young investors to purchase one place at a time and pay it off!!! my wife and I started with a small homes and put our time and money into it until it was paid off then we moved and did that several more times. The trick we found is the super low cost repos, old word frame houses no one wants or even mobile homes on private lots where you own the land and home- now we have a standing 35,000 check for any house that comes open in that price range- you would be amazed how many decent small homes you can buy if you are polite , and quick with a cash offer. You streamline the process by skipping the survey (city lots simply don’t change size..lol) – paying the title search guys yourself and closing in your lawyers office with a warranty Deed- our attorney closes all our deals for 250 bucks and we prepare the Docs…….the best part is it doesn’t matter what interest rates do, our model keeps us making 20% gross on average on every rental.

  2. Peter Mckernan

    Sterling,

    Great point, these rising interest rates can be a game changer, that’s where buying right comes into play even more. If the properties are bought right and we know that an investor makes their money on the buy not the sell of the property, then they should be good to go!

    From 1970 into the late 80’s the mortgage rates jumped into the double digits and investors like Bruce Norris were still able to create a substantial amount of wealth while rates were four times what they are now. Those investors talked about not knowing that rates would ever drop low, and they were surprised when rates dropped to 12% or even 10%.

    We’ll have to watch the rates and in the meantime as you mentioned, partner up, buy right, or build cash until you can buy outright.

  3. Kyle Hipp

    I have been doing 15 year notes for a number of years. This makes my property selection narrower when they still meet my cashflow goals. I am closing on another duplex next week and refinancing another place early in January should have rates locked in at 4.25% on 15 year notes one. These are commercial notes and it is hard to complain with such low rates:) Truthfully I doubt we will see 7.75% rates anytime soon

      • Kyle Hipp

        Since I really started studying the operational realities of our monetary system, I have not really changed my buying criteria. I have purchased the the last couple on land contract and the most recent was a good deal off the MLS from a motivated group of sellers. I m shooting for adequate cashflow and 30% equity within 18 months usually via forced appreciation with a repair and improvement pln.

  4. Though, as interest rates rise, homes will also be less affordable for many buyers which will continue if not increase the demand for rental properties. And, even with financing of around 70% of the property value at the higher rates, the return should easily be better than you can do at a bank.

  5. Steve Vaughan

    Rising rates will definitely affect the BRRRR refi till you die crowd, the adjustable rate and balloon and callable commercial crowd and ultimately asset prices long-term.
    Whoever didn’t lock in long-term, fixed rate residential financing at 65 year lows in the 3s that could have – should have and will realize their miss.
    I still have seller-financed and bank mortgages in the 6s. 4 @ 6%, 6.125%, 2 @6.5% and 1 at 7.99%. My commercial loans are in the 5s. They are adjustable and callable every 5 years.
    With opportunities for new acquisitions low in my seller’s market, I am knocking mortgages off one by one. Once the snowball gets rolling, they fall quickly.
    I bet many more will be open to paying mortgages off in a higher rate environment. Thank you for the article and discussion, Sterling!

  6. Wayne Snell

    I agree with everything Sterling is saying but am confused as to why anyone who got 2,3 or even 4% on 30 yr FNMA fixed loan would bother refinancing in the first place? Most likely the monthly payment hit and reduced cash flow would overshadow any equity they take out. I learned a long time ago from a very wise person never finance with adjustable rates because it will always hurt you. As a Notes investor I see that time and time again where our borrowers started out in the 6% range and have watch their rates go up into the 10-12%s. Naturally when their payments more than double the struggle to stay in their homes. Of course that’s one of the reasons why we invest in this to help them stay and make a win-win

  7. JL Hut

    Fatal mistake most newbies make is assume that tomorrow will be better than today. In my lifetime rates have averaged in the 7 range with a high of 21% (the year I bought my first home). Today is a once in a life time gift, I can buy nice class A home and be positive cash flow, a rare thing in my life time. If your in it for the long term, plan for the worst (much higher rates) and hope for the best, otherwise you may be talking about your real estate investments in the past tense.

  8. Jerry W.

    The bank I use does 15 year loans on a 5 year ARM. They offer a lower interest rate for a 3 year ARM but I avoid those. I use a 15 year note, so loans pay down quickly. I am already paying in the 5% range and see rates going up more. If I do an 80% loan and pay using a 15 year mortgage, I am basically at 60% purchase price on what I own. I usually improve my properties or buy distressed so I am easily at 50% equity to loan ration. In a pinch I could refinance these properties to 30 year loans and absorb an interest rate increase to 10%. My plan however is to pay them down as quickly as possible so I can quit the day job. In 3 years several of my mortgages will start being paid off, so hopefully the snowball effect will enable me to pay more mortgages off quickly. I did refinance many properties for a few years in order to get cash for more down payments on new properties. That strategy has risks and decreases cash flow as well as extending pay off dates, but I was able to grow my portfolio. While it took time I was able to grow a decent sized portfolio with less than $50K out of pocket. Now to get it paid off.

  9. John Barnette

    The biggest threat is a 70’s style stagflation. Higher rates and stagnant economy and wages. I do wonder what happened with rents and property values during the 1970’s adjusted for inflation. I think generally speaking higher interest rates would correlate with a stronger economy with wage growth, higher corporate profits, etc. Thus rent rates and values should also be increasing. Low rates to correlate with relatively weak economy and low job growth, etc. At least un theory. Yes current rates are low and have been historically low. However also low in just about the entire developed world. And the US appears to be the stronger economy now (and thus increasing rates). However…if US rates are higher than other countries, the dollar will be stronger, export economy weaker, international monies will flow increasingly to US treasuries..ultimately driving down rates. I woild like to hear from investors who were active in the 70’s and folks who understand what brought on the double whammy of stagflation. That is what I ultimately worried about. Great conversations

  10. Ross Bagley

    I don’t see any significant changes to the plan coming in the near future. I always use fixed rate loans to hedge against future variability, so no need to stress out about ARM adjustments or similar kinds of nonsense. With a fixed rate note, as long as the numbers work, the numbers work. I buy vacation rental homes so I’m in a slightly different situation from others. I usually have more headroom before I go cashflow negative, which is nice. However, my rents come from disposable income, not fixed expenses, so I feel the hit of a downturn before traditional landlords, which isn’t as nice…

    I may be projecting average booking rates and vacancy proportion a little more conservatively until I see what happens to the economy during this next presidency. Best case, things are more inflationary, so interest rates rise, but so do incomes and property prices, and my existing low interest rate notes with reasonable leverage are perfectly positioned, while I’m continuing to buy new properties when the numbers work. Middle case, stagflationary situation means that I probably get a lot closer to break even than I projected on existing properties, but appreciation generates paper income that will be realized once things stabilize. Worst case, canned food, ammo and toilet paper FTW!

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