Investors: Let’s Talk About Rising Interest Rates

by | BiggerPockets.com

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.

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?

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

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

17 Comments

  1. Christopher Smith

    No one has crystal ball, buy I think dire predictions of inflation are still overly influenced and burdened by the mentality of those who lived through the late 70s and early 80s. A number of current economic factors might tend to mitigate against inflation coming back with a vengeance, and hence significant increases in interest rates by the Fed.

    1) Energy supplies are vastly plentiful, so that price risk (a huge risk in the 70/80s) is largely in check.
    2) The competitive market place is now the World stage (also very different from the 70/80s), so the ability to raise prices on many goods is highly constrained by a multitude of various foreign players who a more than eager to nimbly step in and undercut domestic players on the sales of those goods.
    3) While nominal unemployment is low, its not as low as it appears since many unemployed are classified as having “given up the serach for a job” and are no longer counted for purposes of the reported numbers (which is also different from the way these numbers were calculated in the 70/80s). These people represent an addition to supply of labor overall.
    4) Until very recently the Fed was actually struggling mightily just to get the inflation numbers up to 2%, not attempting to push them down.
    5) Productivity gains appear to be accelerating significantly in certain new and old economy industries so wage gains are not necessarily solely attributable to inflationary forces.

    So will rates still go up, sure probably some. Personally, I think the Fed wants to give folks the IMPRESSION that it will push up rates far more than it will actually do so, if for no other reason than to dissuade people from increasingly reaching for additional investment yield (to replace low interest CDs, etc.), thereby incurring additional risks that they are not really able to fully appreciate or financially assume.

    Additionally, raising interest rates significantly is very problematic for a number of reasons.

    1) As has been evidenced most recently, it creates potentially massive instability in the equity markets and not just the US but on a fully WorldWide basis – no one needs another titanic stock market crash (e.g., all of the U.S., China and EU are just now recovering from the last equity blast)
    2) Given our country’s hugh debt load even minor increases in rates will result in Treasury interest payments that will totally blow out budget deficit numbers which are already staggeringly high.
    3) The same effect will occur for highly levered US firms of which there a quite a number.
    4) It will also make it much more difficult for our multinationals to compete overseas (as it will increase the value of the dollar vis a vie other currencies), and US competitiveness is something the current administratin is aggressively trying to advance not retard.
    5) Even the new tax law specifically and significantly restricts interest deducutions by most businesses (not RE though), so any additional interest expense would potentially be totally wasted for US tax reporting purposes massively increasing the after tax cost of debt – this for both new and existing debt.

    • Cindy Larsen

      Christopher,
      Great post. Everything you said makes sense. unfortunately the stock market’s reactions and what make sense do not intersect in any predictable way. Nor aremthe decisions of the government with respect to interest rates very predictable. Unfortunately in both of these arenas perceptions seems to be as important as reality, at least in the short term.

      The behavior of a significant number of stock market investors resembles that of lemmings, as they follow the crowd, creating positive feedback the exagerates events: “oh look, the stock market indices went down, And some random pundit says a crash is starting, I’d better sell now before stock prices drop more!”. This kind of thinking, of course results in prices falling more. Eventually, others see the drop in stock prices as an opportunity, and buy, which drives prices back up. What we need, to solve the current stock market problem, is some pundits publishing articles with titles like “stock market about to recover” or “good long term outlook for stocks”. Given the economic climate, which you described far better than I could, the stock market will go back up. We just have to wait, and ride the roller coster. I hate the stock market, and am transfering out of it and into more real as soon as feasible (buy low, sell high, and I don’t think right now is the time to sell) Real estate makes sense.

      Interest rates will, no doubt, go up, if for no other reason than that the intention to raise them three times this year has already been announced. The fed wouldn’t want to look indecisive, after all. Unless they can spin the news coverage so they look wise and benevolent for not raising interest rates, because of troubles in the stock market. I’m personally hopeing for that scenario.

      The truth is, that us lowly real estate investors have no way to predict inflation, or interest rates, or the stock market, or the real estate market even. the best thing we can do is to run the numbers before we buy a property.

      Does the property still cash flow if the interest rate goes up by a quarter point? Half point?
      Will I be able to refinance, or sell, in a higher interest rate market?
      What will be the impact of inflation on my ROI?
      What is my strategy if the real estate market drops by 1%? 10%?
      Do I have multiple exit strategies for this property? What would trigger each one?

      My approach is to run as many scenarios as I can think of, and then make a decision based on my best educated guess as to whether that particular property, at that negotiated price will have a positive impact on my long term net worth. Running as many scenarios as I can helps me make better decisions, but a lot of it is still guesswork. The BP calculators are great, but they are also only as good as the numbers you put into them: Garbage In, Garbage Out.

      The BP calculators,also do not take taxes into account: which can lead to problems in predicting your actuall ROI. What is the ROI at a 28% marginal income tax vs 25%. What if, for example you can’t take depreciation on a particular property, this year, and have to roll its depreciation to a later tax year? How does that affect your exit strategy?

      I really want a crystal ball, but lacking that, my answer is to only buy really good deals, based on the best info I can find. In this market with prices high and interest rates rising, that means being very careful. And, paying down my highest interest rate loan with profits from properties will lower loans.

      • Christopher Smith

        I like the lemmings reference for two reasons.

        1) Its amusingly descriptive of the “crowds” mentality and reaction

        but also because

        2) Where the lemmings maddingly swarm, opportunities often flow most abundantly (its then the charge of the highly discerning and disciplined investor to take advantage of the chaos)

  2. Ben Leybovich

    Christopher – all good points. My concern is that we are in a space whereby even an insignificant increase in rates is problematic for a lot of people. Why? Because of exuberance relative to investment decisions which is teed up on low rates.

    I am still on the side of buying if the opportunity is there. However, the devil is in the details of what defines “opportunity”…

  3. Wilson Churchill

    The trade deficit must be addressed. Raising rates without addressing the trade deficit won’t work, at least not without defaulting on the national debt. Trump had the right idea when he said that correcting the trade deficit and growing the economy would pay the debt. Unfortunately, the trade deficit is now larger than ever. Until he directly addresses NAFTA and implements high tariffs, we are headed for default or inflation.

    I always look to buy, but only at a significant discount. I am strongly considering selling my two most expensive rentals before rates increase too much, and deleveraging.

  4. Great article Ben. I really like discussing economics. Sick I know. So here are a few random thoughts;
    1) If someone is priced out by a .25 or .5 rate increase, doesn’t that show / prove they were not in a great position to begin with? I mean if they no longer can afford to buy with slightly higher rates, what would they have done if a furnace went out, a car broke down or their OT went away? Maybe they are just trying too hard and this is the market telling them to reconsider.

    2) Even with a slight increase in rates, they are still relatively low when viewed historically.

    3) isn’t this ONE of the reasons we buy real estate in the first place, a hedge against inflation? I know rate increases and actual inflation are not the same but they are tied together.

    4) There are good things about inflation and the Feds attack on it.
    4a) We are paying off our mortgages (fixed expense) with inflated dollars assuming rents go up.
    4b) This may be the incentive needed for some to de-leverage or at least consider it a bit.
    4c) fewer qualified buyers means more opportunity for those who DO qualify.

    As mentioned above, inflation has STRUGGLED to reach 2% for the past 9 years. A forecast for 3%-4% is not cause for panic but rather a cause for celebration on many fronts. Given the Fed debt service will increase with rising rates, they are not anxious to do so. Not trying to get too political or conspiratorial but the markets are reacting to what the OUTGOING (read Obama’s) Fed chairman said. Now given that Trump has taken a lot of credit for the stock market run up, this may be an attempt to cause some uncertainty and knock him down a peg or two. If this was intended or not, that is what is happening. Equity market turmoil based on a comment.

    Thanks again for your insightful articles.

    • Cindy Larsen

      Tim,

      Good points expecially about inflation. But your best point was “Equity market turmoil based on a comment.” Exactly! the stock market keeps doing this, and with the modern speed of information, the feedback loops resulting from opinions and comments are quite dangerous.

      Most of my retirement funds are invested in the stock market and it feels like riding a tiger.

      “ To have a tiger by the tail refers to the act of having ’embarked on a course of action that proves unexpectedly difficult but that cannot easily or safely be abandoned’. Similar to this phrase is the Chinese proverb ‘He who rides a tiger is afraid to dismount’, which gave rise to the phrase ride the tiger.” Oxfordwords blog Jul 29, 2015

      Dismounting from 401ks invested in stocks is proving “unexpectedly difficult”, and the complexity of the IRS’s future involvement with my funds is like navigating a swamp filled with alligators eager to remove body parts. Real estate investment is the light at the end of the tunnel. No more stock market volitility based on perceptions. No more surprises like the IRS’s Required Minimum Distributions. Real estate is something understandable that will NOT loose me wealth, but will instead generate it, as long as I make sound investment decisions. I’m not sure it is possible to positively identify a sound investment in the stock market.

  5. “Should said cost of ownership go up, the income needs to go up as well in order to preserve the DTI relationship.” Or as often happens, house prices come down. Maybe if interest rates go up, house prices will reconnect to the wages that pay the payments. In many markets, even in Arizona, house prices are out of sync with median wages of prospective homeowners. With higher interest rates, maybe houses prices could come down, lenders still win, and savers get something for their savings. A healthy economy should lift all boats, as the cliche goes.

    • Darin Anderson

      House prices are not coming down based on wages or interest rates. They will come down when supply exceeds demand. That is what happened in 2008.

      Lets look at the run up and the collapse.

      Run up:
      1. Wages were unexceptional
      2. Interest was low (but not as low as it was after the crash)
      3. Sale of existing houses was very high and people were turning over and upgrading their houses.
      4. Supply of new houses was being built at 2 million units per year.

      Eventually supply was so high that there was no one left to buy more houses so ….

      The collapse:
      1. Wages got worse.
      2. Interest got lower.
      3. Sales of houses at first dropped like a stone, then the foreclosures came and sales went back up at 50% off.
      4. Supply of new houses being built dropped to 300,000 units per year.

      And now:

      1. Wages have been stagnate for many years and are slightly creeping up but still quite unexceptional
      2. Interest has been exceptionally low for many years and are slightly creeping up but still quite low.
      3. Number of existing houses for sale are very low. 3-4 months supply. Below 6 is healthy and these numbers make for a very tight market.
      4. Construction of new units is at 600,000 per year. Far below the peak and well below the 40 year average of 1 million units per year.

      Houses prices ride on the same thing all prices ride on: Supply and demand.

      Right now supply is very low and demand is running quite high. Demand could be slightly reduced by rising interest rates, but it has a long ways to go to get it low enough that supply outstrips demand and that is the only thing that is going to lower house prices. Significant house price declines are not on the near term horizon.

      • It is not either-or. Supply and demand is one factor. The interest rate is another factor. When the interest rates dropped, agents told buyers, “Now you can buy more house.” Instead, buyers ended up paying more for the same house as houses prices rose to maintain the same level of payments according to the debt to income ratio.

        Some of your conditions were operative in the run-up, but I would not say people were upgrading their homes. I o0nly saw upgrades after the crash. Pre-crash they were using home equity loans and cash-out refis to raid their equity to spend on other things. One of the main characteristics of a foreclosed home was severe deferred maintenance AND the presence of a relatively recent refi based on a paper appraisal using out-of-line comps.

        The problem was not that supply was so high. In fact, just the opposite. There were buyers, but no reasonably-priced homes because of the inflated prices totally disconnected from those stagnant wages you mentioned. There is no healthy reason why houses appreciating at the historical rates should suddenly sell multiples of those rates. There was no one left to buy because the supply has priced them out. Meanwhile, agents betrayed their fiduciary duty to their buyers by advising them to hurry and buy before prices totally exceed affordability even if they have to get a negative amortization ARM loan to do so. “Don’t worry,” agents said. “House values only go up. Just refi when your house gets some appreciation equity.” What did these agents care. They got their commissions and walked away from the financial time bomb they put their clients in. Not their problem.

        However, I agree that significant house price declines are not on the horizon. There are people who are stilled anchored on the phony values of 2006. “Recovery” was the wrong media frame for the desire to reinflate house prices. “Relapse” would have been a more accurate frame. It was completely irresponsible for the real estate industry with the help of the media to push for a relapse to unhealthy inflated house prices.

        The present interest rate is too low, and benefits only a small segment of the American population. Most Americans simply paid too much for the same house. A healthy interest rate would benefit a greater cross-section of the population. The real estate industry has really led consumers astray by socializing them to prioritize the interest rate over the principal. The principal is the more important than the interest rate.

  6. Lewis Christman

    I think this comment is 100% wrong = “She said, “People who could qualify for mortgages last week, can’t today.”. If they qualified yesterday then they qualify today (outside of loss of job or change in underwriting standard which do not change that quickly) they just don’t qualify for the same loan (dollar) amount.

    I like to say a bank will give you 9 loops on an 10 loop noose neck tie. They will try to max you out (28% DTI on a gross perspective is a lot different on a net perspective after saving for retirement and all other deductions). And yes I know some agents that will push you to the max of that amount because there is more commission $$$$.

    If / when interest rates rise people will be able to afford less which will eventually put pressure on home prices (want to sell your home you will need to reduce your price). The higher my costs the less I will pay because I want positive cash flow of 150 or more per door.

  7. Mark alpert

    Lots of good questions, but I think the most important is, are you really having a Reuben for breakfast?

    As for reading the tea leaves, interest rate hikes will contribute to the sense that the market has reached a top. Prices will rise as long as people think they will keep rising, and then some day they will stop thinking that and they will start falling.

  8. Rob Cook

    Another way to look at this situation is to consider that buyers will pay more IF they can. In other words, since few homebuyers are cash buyers, then their ability to pay is directly related to how much they can borrow. And the fact that they WANT to buy badly, and are willing to pay more, is throttled, eventually, but a lender’s willingness to lend to them for the purchase. And that is where the relationship between interest rates and lender qualification standards does affect the real estate market – demand side. So, demand is ultimately more objective than the mere desire and willingness of a buyer to pay up for housing would suggest. Reality dawns and house prices will adjust accordingly, for those sellers who need to sell. The 2008 financial crash was due to lenders failing to act as the throttle. Not likely to occur again this time?

  9. Bill Perry

    A ruben for breakfast really makes a lot of sense.

    It’s good to get some sauerkraut in your gut first thing in the morning not only for adding acid to stomach juices (which allows the lower stomach valve to open and saves you from acid reflux by moving the meal along), but also for the probiotic cocktail which enriches gut flora and therby vastly improves the immune system preventing you from picking up a case of influenza.

    The corned beef contains just enough fat to hold off those 10:30am hunger pains and even out your blood sugar, which keeps your brain cells fed in order to make wise REI decisions.

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