Why interest rates matter in real estate investing

The Federal Reserve has been aggressively raising interest rates, with 11 hikes since 2022, in an effort to curb inflation that has been running catastrophically high. These interest rate increases affect the real estate market because they drive up the rates banks charge for commercial real estate loans. 

As the Fed pushes rates higher and higher, the interest rates lenders can charge on commercial real estate debt rise in tandem. With higher debt costs eating into property cash flows, maintaining positive leverage will become increasingly difficult.

By learning about how interest rates affect real-estate investing understanding, you can improve your decision-making and confidently shift throughout real estate cycles.

This article provides a comprehensive overview of the dynamics between interest rates and real estate investing. It explores the key factors investors must grasp, like impacts on property values and cash flow. 

Why interest rates matter for property investors

Interest rates and investing in real estate are very closely related — you can’t really think about one thing without thinking about the other. 

Thus, interest rates are a crucial variable for real estate investors to understand. Fluctuations in rates have a direct effect on property valuations, cash flow levels, and overall investor returns. 

As rates move up and down over time, they influence real estate markets in a significant way. Gaining a solid comprehension of how interest rates function and impact real estate is foundational knowledge for anyone investing in property.

How interest rates affect property values

Interest rates have an inverse relationship with property values. As interest rates increase, property values tend to decrease. As interest rates fall, property values tend to rise. It is because interest rates impact the cost of borrowing and mortgage payments for homebuyers.

Higher interest rates mean higher mortgage payments for buyers. With higher monthly costs, buyers cannot afford to pay as much for a property. Lower demand leads to declining property values. During periods of low-interest rates, buyers can qualify for lower mortgage payments. With lower monthly costs, buyers can afford more expensive properties. Higher demand leads to rising property values.

For example, if mortgage rates rise from 3% to 6%, the monthly payment on a $300,000 loan would increase by more than $500 on a 30-year mortgage. You can experiment for yourself with a mortgage calculator.  

With that higher payment, a buyer may only be able to afford a lower-vale property instead of aiming for a $300,000 mortgage and would opt for a smaller-size one. Across the entire real estate market, this dynamic leads to lower prices when rates are high and higher prices when rates are low.

How interest rates impact property values

In order to illustrate this relationship, let’s look at the following scenarios, remembering that interest rates and property values tend to have an inverse relationship:

• As rates rise, values tend to decrease.
• As rates fall, values tend to increase.

Why this happens when rates go up:

• Higher rates mean higher mortgage payments for buyers.
• With higher monthly costs, buyers can’t pay as much for properties, most likely leading to lower demand and declining property values.

Why this happens when rates go down:

• Lower rates mean lower mortgage payments for buyers.
• With lower monthly costs, buyers can pay more for properties, typically leading to higher demand and rising property values.

A real-world example of a prospective homebuyer

As a real-world example, let’s consider a first-time buyer of a house in Seattle who can make a 25% down payment on a $400,000 property with $100,000 in equity. The buyer’s budget for a 30-year mortgage is $1,600 per month. 

If mortgage rates are at 3% for a 30-year mortgage:  

• The buyer can afford a monthly payment of $1,600 for the 30-year mortgage and can purchase the property for $400,000.

If mortgage rates rise from 3% to 6% for a 30-year mortgage:  

• The monthly payment on a $300,000 loan increases by around $500 to $2,100. 
• The buyer can’t afford the higher monthly payment anymore. 
• The buyer can’t access additional equity to lower the mortgage amount. 
• Instead of being able to pay $400,000 for the property, the buyer can only offer a lower amount to secure this property or will settle on a different, more affordable property. 

If mortgage rates rise from 3% to 8% for a 30-year mortgage:  

• The monthly payment on a $300,000 loan increases by around $900 to $2,500.
• The monthly payment needed is now more than 50% higher vs. mortgage rates standing at 3%.
• The buyer can only afford a much more affordable property or will need to put up additional equity in order not to hurt his or her budget.
• Overall, such a situation tends to affect property prices negatively over time, as people can afford only a smaller mortgage notional. 

Positive leverage vs. negative leverage

Rising rates do not only affect affordability and prices but also returns and cash-flows on development and investment properties. The two common terms used to describe the impact of debt on real estate investment returns are positive leverage and negative leverage. 

Positive leverage

Positive leverage occurs when the annual cash flow yield on a property, calculated as the net operating income divided by the purchase price, exceeds the interest rate charged on the debt. 

This positive spread enhances overall returns since the leverage provided by debt magnifies the cash flow. For example, as illustrated in our video below, a property acquired at an 8% capitalization rate with 60% loan-to-value debt at a 5% interest rate will produce a 12.5% cash-on-cash return thanks to the 3% positive leverage spread. 

Conversely, negative leverage results when the interest rate on the debt is higher than the cash flow yield. 

Negative leverage

With negative leverage, the debt service consumes the majority of cash flow which severely reduces returns. For instance, debt at an 8% rate on a property with a 5% capitalization rate nearly eliminates cash flow (as in the illustrative example in our video). 

If net operating income were to decrease due to factors like a declining local economy, negative leverage could also result in capital calls as cash flow turns negative and the investor has to contribute additional equity to keep the property afloat.

Risk of loss with both positive and negative leverage

It’s important to understand that even deals with positive leverage can lose money if net operating income declines rapidly. In the example provided, the property was acquired with 60% loan-to-value debt at a 4% interest rate, while the capitalization rate was 6%, creating a 2% positive leverage spread. 

However, as an example, due to issues like high inflation, a major employer leaving the area, or poor property management, net operating income decreases to 2% annually over the hold period. 

Despite maintaining positive leverage throughout, the erosion in NOI is outpacing the debt service, leading to a 20% loss when the property can be sold 5 years later. This illustrates that positive leverage does not guarantee a successful investment if the underlying real estate fundamentals deteriorate. 

Careful underwriting is essential to ensure assumptions about income and expenses are realistic and to evaluate external risks. While positive leverage can enhance returns on performing assets, it can also exacerbate losses on poorly performing properties as fixed debt service obligations remain while cash flow declines.

Leverage with development projects

It’s common for new development projects to experience negative leverage in the initial years before the property is completed and stabilized. Since there is no income stream during construction, the interest expense on construction loans creates negative cash flow. 

But this is typically expected to reverse once the project is finished and tenants start paying rent. 

Additionally, cap rates can vary significantly by location and asset type. For example, cap rates for multifamily properties in suburban markets will differ greatly from cap rates for office buildings. 

Being knowledgeable about the typical cap rate ranges and trends in your specific market is key to underwriting deals appropriately. Finally, some investments can show high cash-on-cash returns in the early years that obscure underlying issues. If net operating income is falling each year, that declining NOI could eventually lead to lower property values and investment losses down the road. 

Maintaining a focus on fundamental performance metrics like NOI growth is critical, as initial high yields may divert attention from problems developing with the asset or market.

How to manage interest rate changes as a property investor

For real estate investors, there are several strategies to consider for managing interest rate risks:

Navigating interest rate fluctuations is a key part of real estate investment strategy. Investors have several options to mitigate interest rate risk. Financing with fixed-rate loans locks in a constant rate for the full loan term, protecting against rises at the cost of missing out on declines. 

Shorter loan terms require refinancing more often, allowing investors to capitalize on falling rates, if the tide turns. Paying down debt ahead of schedule leaves less outstanding principal vulnerable when rates eventually increase. 

Conservative underwriting bakes in assumptions of higher rates and lower valuations to cushion against market downturns. Maintaining ample cash reserves gives a buffer against tightened cash flow during times of high rates. 

Factoring realistic rent inflation provides offsetting income to cover increasing mortgage payments. Finally, investing in niche property types could provide strong yields even in high inflation, and high rate periods. Understanding these strategies allows investors to craft a tailored approach to interest rate risk management.

Effective strategies to manage interest rate risk on properties

While there are different ways to deal with a challenging interest rate environment, the following strategies are prudent ways to protect from rising rates: 

• Financing with fixed-rate loans: Fixed-rate mortgages lock in a constant interest rate for the full loan term. This protects investors from rising rate environments at the expense of missing out on lower rates.
• Financing for shorter terms: Shorter loan maturity dates mean repricing at current market rates more frequently. This allows investors to take advantage of declining rate environments sooner.
• Paying down debt: Accelerating principal paydown when rates are high leaves less outstanding debt to be impacted when rates rise in the future.
• Factoring rate changes into valuations: Conservative underwriting builds in assumptions of higher interest rates and lower valuations to cushion against downturns if rates increase.
• Growing cash reserves: Maintaining higher cash reserves provides a buffer against reduced cash flow in higher-rate environments.
• Incorporating inflation: Factoring realistic inflation assumptions into rent growth projections to offset rising costs including higher loan payments is crucial.
• Investing in alternative property types: Certain property like storage types may provide higher returns in high inflation, high interest rate environments.

Key takeaways on how to deal with rising rates as a real-estate investor

Interest rates are a critical variable that impacts real estate investing. Here are some key takeaways:

• Rising interest rates typically lead to lower real estate values and reduced cash flow while declining rates do the opposite.
• Interest rates directly influence investor returns through their effect on property prices and cash flow.
• Proactively managing interest rate risks by using fixed-rate financing, paying down debt, and building cash reserves can help investors reduce downside risk.
• Factoring realistic interest rate assumptions into valuations and projections is key for conservative underwriting.
• Different property types perform better in certain rate environments, providing diversification options.

Understanding the dynamics between interest rates, property values, cash flow, and returns is foundational knowledge for real estate investors. Making smart financing and risk management decisions allows investors to strategically navigate any interest rate environment.

By taking a proactive approach to managing interest rate risks and applying some of the principles in this article, investors will be able to steer through difficult times like the current ones.