How not to act in a rising interest rate environment

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We’re living in a world of rising interest rates, which are already fundamentally changing the real estate market.

As discussed yesterday, as interest rates rise, prices should fall, all other things being equal. That’s because more expensive debt means reduced cashflow and lower returns at a given price.

But, all things are not equal. In general, assuming a normal economy, interest rates should only rise when things are improving. Why? Interest rates are effectively the price of borrowing money. When the economy is bad, and there is not much opportunity, no one wants to invest in new opportunities, so the demand for money is low and the price (the interest rate) falls.

On the other hand, when the economy is promising, everyone wants to borrow to expand their businesses, buy assets, fund consumption (cars, boats, etc.) So, demand for money increases and interest rates rise.

The fact that interest rates are going up isn’t necessarily such a terrible thing. It is, in fact, a strong signal that the economy is improving.

The trick for real estate investors is to figure out how to benefit from an improving economy without being hurt unduly by the rising rates.

Here’s an example of what not to do:

  • Pay a high price (say, over 11x) for a rent controlled property with tenants at below market rents
  • Use a 3- or 5-year fixed rate loan for a very large portion of the purchase price (say, 75%)

Why is that a bad play?

  • You paid a high price, so your cashflow is pretty slim to begin with;
  • Your tenants aren’t leaving, so you’re limited to increasing the rent by the city-mandated 3% / year, meaning that you’re not really benefitting that much from improvements in the economy;
  • Interest rates go up in the interim, maybe to 6-7% (they were that high as recently as 2008);
  • After 3 or 5 years, your rate comes unlocked and your debt payments increase, eating up most/all of your slim cashflow;
  • When you go to refinance, depending upon how much multiples have dropped as a result of the increased interest rates, you may find that you lack the equity necessary to refinance and are therefore stuck with whatever rate your loan has adjusted to.

The above is pretty obvious to me, and yet I see poorly advised investors buying exactly this type of deal all the time.

Tomorrow, we’ll talk about some better strategies for investing in a rising interest rate environment.

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