28 Jun What Do Higher Interest Rates Mean For Us?
The Effect of Rising Interest Rates & Why It May Be Good For Real Estate Investors
Looking at the blog What will Higher Interest Rates Mean…
We’ve been living in an artificially low-interest-rate environment for the last decade. As a result of lenders’ inadequate due diligence and underwriting procedures, real estate investors have had access to inexpensive cash.
However, the effects of the Great Recession are still fresh in the minds of many long-term real estate developers and investors, and this hasn’t hindered a historic bull-run that has sent real estate prices to heights never seen
before.
Rising interest rates are here. Year over year inflation is at its highest level in more than 40 years (longer if they calculated CPI the same today as they did decades ago). And, in order to prevent runaway inflation, central banks can control interest rates in order to slow the economy and the rate of borrowing.
Higher interest rates, according to Keynesians and mainstream economists, are bad for the economy because purchasers will no longer be able to afford homes, and the economy would grind to a standstill.
However, this is not always the case.
In this post, we’ll address some popular misconceptions concerning interest rates and real estate, as well as explain exactly what real estate investors, company owners, and developers need to know moving forward.
Interest Rates & Home Buying
Rising loan rates appear to make house purchase more challenging. A 100-basis-point rise, for example, may add several hundred dollars to a $350,000 mortgage payment. It indicates that the cost of borrowed money increases during the life of the mortgage, and so the borrower pays more interest. On the selling side, when interest rates increase, potential purchasers may be unable to pay what they could in a low-rate economy. As the pool of possible purchasers shrinks, so will the demand for the property. Rising interest rates may make it difficult for sellers to maximize the value of their property sales or capitalize on a big buyer pool.
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Real Estate Investment Values
To comprehend how interest rates affect real estate values, we must first examine how real estate values calculated. The price of real estate, like the price of any other goods or service, is usually determined by the market’s supply and demand. The extended historically low-rate environment that we’ve been experiencing over the last decade or so has resulted in a surge in demand for cash flow producing rental properties, and thus an increase in real estate investment prices.
However, the rule of supply and demand only tells part of the tale of real estate investment valuation. There are three approaches to valuing income-producing real estate: comparable sales, replacement value, and income method. For the purposes of this debate, we shall concentrate on the income approach.
The income approach is comparable to a typical discounted cash flow (DCF) analysis seen in other sectors of finance. The property expected to generate rental income and generate positive cash flows. The operational expenses of a property are then tallied and any capital expenditures linked with the long-term care of a property are also considered. Finally, the discount rate applied to all future cash flows to calculate a real estate value in “today’s” dollars.
However, this is where interest rates come into play.
Capital allocation decisions made by investors based on relative risk and the opportunity cost of capital budgeting decisions. The discount rate applied to a real estate investment equals the entire necessary return for a project. The overall return required is impacted by the project’s risk and the potential return from another investment (risk-free rate + risk premium).
Because the risk-free rate is sometimes substituted for the return on a treasury bond with a comparable end date to your project, when interest rates rise;
As a result, as interest rates rise, the value of real estate assets falls. Projected cash flows are discounted at a higher rate and investors must be paid for that investment risk/opportunity cost by buying a property at a lower price.
Why Rising Interest Rates May Not Be A Bad Thing For Real Estate Investors
We all know that interest rates have an impact on mortgage rates. We also understand that interest rates influence an investor’s capitalization and the discount rates used to value a property. As interest rates rise, the spigot that controls the flow of accessible capital begins to constrict. This is usually seen negatively by real estate investors because underwriters tighten their standards, making it more expensive to fund projects.
However, this could be a positive thing. The recent decade’s rising tide has lifted all ships — nearly uniformly, real estate values have climbed; even unskilled investors have “win” if they invested in property. It was true for investors with both fantastic and average business proposals. It was true for careful investors who underwrote properties, but it was equally true for careless and cavalier investors.
Real estate investment community became arrogant, believing that they’d cracked the code and knew the secrets to real estate investing. Yet, that expansion fueled by record low interest rates.
The value appreciation and rent rise we’ve seen have obscured many of the investors’ shortcomings.
So, what happens when monetary policy starts to tighten?
Finally, you’ll see a more efficient allocation of resources into real estate.
Every part-time investor who has flooded the market in recent years will be unable to compete. Good business ideas will begin to outperform bad company strategies. Because novice investors will have a more difficult time raising funds for businesses & will be able to out-compete the masses.
Realistic underwriting will be more important to success than the overly optimistic refinance assumptions; Rent growth forecasts we’ve become accustomed to seeing in preforms in recent years. Rising interest rates will provide investors with a 12–18-month window of opportunity to profit from market disruption.
Individuals will begin to make more reasonable decisions about capital allocation. As the distortion of central planning subsides, the free market will begin to reward investors who provide a competitive advantage.
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