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May 3rd, 2016 by Marco Santarelli
Home-buyers rejoice when interest rates drop, but rising interest rates can actually be a good thing for investors. Because high rates make homes less affordable, the rental market improves, giving real estate investors a chance to improve cash flow and increase their return on investment.
For investors participating in all-cash deals, higher interest rates don’t have much of an impact on the cost of acquiring new investment properties. Investors who rely on financing will pay more for residential and commercial buildings, but the positive effects of rising rates should cancel out most slight increases in costs. Any investor with an existing variable-rate mortgage should expect to pay slightly more each month. For example, a 0.25 percent increase in the Fed rate could increase mortgage interest rates and the cost of borrowing for an investor.
When interest rates increase, buyers have several options. Making a large down payment or buying a less expensive home are both good ways to reduce the amount of financing needed, but these options just are not feasible for all buyers. It’s also possible to take a variable-rate loan with a low starting rate, but many buyers are more comfortable with fixed-rate mortgages.
When rates increase, some buyers stop shopping for homes and decide to rent until rates decrease. This is great news for investors. As the demand for rental units increases, investors are able to raise rental rates, increasing their monthly cash flow. If an investor owns a 4-unit property with a 100 percent occupancy rate, raising the rent by just $100 per month results in an extra $400 of income per month. The extra money can more than make up for the slight increase in mortgage costs related to rising rates.
Rising rates can also have a positive effect on occupancy rates in the rental market. When rates are low, it’s more affordable for renters to finance home purchases. As a result, some renters decide to buy their own homes, leaving investors with vacant units. When interest rates increase, renters are more likely to stay in their units, keeping occupancy rates steady.
In addition to influencing the amount of mortgage capital available, interest rates also influence property values and net operating income (NOI). If an investor is able to raise rental rates without incurring additional expenses, NOI increases. Provided the property’s value stays the same, an increase in NOI results in an increased cap rate. Increased occupancy rates also have a positive effect on NOI. Rising interest rates often lead to decreased demand, lowering the value of some properties. However, the increase in NOI is often enough to offset a small decrease in property value when calculating cap rates.
The Fed rate heavily influences much of the activity in the real estate market, but rising rates are not always a bad thing for investors. Higher rates do increase the cost of purchasing an investment property, but they also have a positive effect on rental rates, occupancy rates and cap rates.
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