By Drew Reynolds
The choice of an investment strategy is not made in a vacuum. In addition to their personal investment goals and risk tolerance, investors should consider the current state of the economy and how that will affect returns in the future. Unfortunately, given the often unpredictable nature of the market – with its supply chain issues, rising inflation that can be more than transient, and labor shortages, among other challenges – it can be difficult for investors to decide how to manage what may come next.
Another factor investors will need to consider is how to manage investments in a rising interest rate environment. While real estate can serve as a hedge against inflation and can generally offer the potential for positive returns as property values tend to increase over time, interest rates are part of the investment equation that all investors – especially those wishing to own investment properties – will need to take this into consideration.
How are interest rates changing?
Mortgage rates hit historic lows during the pandemic. These rates remained at a low point throughout 2020 and 2021, leading to a very competitive real estate market and exploding demand for new properties given historically low borrowing costs.
However, things have started to change as we move forward into 2022. Mortgage interest rates have been rising at a steady pace. The average rate for a 30-year fixed rate mortgage reaches 3.5% the last week of January, making them the highest mortgage rates we have seen since the start of the pandemic.
The Federal Reserve expects raise short-term interest rates throughout 2022. These rate increases are consistent with ongoing economic growth, which is also being triggered by stock-outs due to supply bottlenecks. They also aim to tackle the current surge in inflation, which remains one of the Fed’s key mandates. Higher interest rates will deter consumers from taking out loans, which will slow the economy and eventually curb inflation. Investors and future homeowners will need to prepare for these ongoing changes until the economy stabilizes by budgeting for higher interest rates when making investment decisions for properties.
What do changes in interest rates mean for real estate investing?
This increase in interest rates will affect each investor differently depending on their personal strategy. Investors considering selling can potentially expect strong returns, but buyers will likely find themselves paying more. Additionally, for investors wishing to sell their investment properties, there are additional considerations for where to invest these products.
Home prices are not expected to decline in 2022, although growth will slow as last year’s hot market cools. Currently, home prices are expected to increase by approximately 7.5% this year, which means investors looking to buy new properties will continue to face high purchase prices.
Rising interest rates increase the cost of borrowing and can make monthly payments less affordable compared to borrowing for a period of time with lower interest rates. For example, if an investor borrows $200,000 and has a 30-year fixed term loan at 3.5% interest, his monthly payment would be $898. By comparison, if the investor borrowed the same amount of money with a 30-year fixed term loan at 2.5% interest, their monthly payment would be $790. That’s $108 a month, for 12 months a year, over a 30-year loan – that 1% difference in interest rates can quickly add up, and for investors needing more than 200 $000 to buy an investment property, this difference in interest rates will feel higher.
In the short term, these rising interest rates may make buying new properties more expensive, but that doesn’t mean there aren’t options for investors looking to buy property in the surrounding area. current. Between rising interest rates and rising real estate costs in competitive markets, some investors have turned to Delaware Statutory Trusts (DST) as potential investments. Investing in DSTs can provide co-ownership in commercial real estate not typically available to investors, and they offer a pre-packaged investment solution that can be tailored to meet an investor’s needs.
DSTs are comprised of different types of commercial real estate investments, including multi-family, self-storage, or distribution centers, to name a few. If these properties offer shorter rental terms, i.e. multi-family or self-storage, they can potentially offset higher interest rates by increasing rental prices compared to properties that offer leases. longer term like NNN properties. For investors looking to buy large-scale residential or commercial properties, they will want to focus on properties where rent increases are an option during this time.
For investors who already have real estate in their portfolio and the ability to adjust rent, rising interest rates may actually be a good thing. Multi-family residential properties and hotel properties are two examples of properties that offer this option. The investor’s mortgage rate can stay the same (depending on whether they have a variable or fixed rate mortgage), but they can get more out of the property by increasing rental prices. In August 2021 rental prices alone rose 10% nationwide. By having the ability to update monthly rents at the end of a short-term lease (approximately every 12 months) and the ability to update rates daily at hotels, an investor can adjust their rental prices to reflect current market prices more than an investor. who has a property on a long-term commercial lease.
How are real estate investments performing in an inflated market?
Despite the recent increase in interest rates, real estate still serves as a hedge against inflation as it does not always move in correlation with the stock market and can often outperform the rest of the market. According to research from the Wharton School of the University of Pennsylvania, between 1978 and 2011, REIT dividend increases averaged 7.71% per year, while consumer price inflation averaged 3.92%. Private real estate also tends to outperform inflation. From the third quarter of 2020 to the third quarter of 2021, the annual GDP growth and inflation rates were 4.9% and 5.4% respectively, while according to the Index of CNRIEF propertiesprivate real estate posted an annual rate of 12.1%.
Investors should expect mortgage rates to continue to rise throughout this year and potentially into 2023, and should consider these factors before investing in new properties. It will take time for the economy to stabilize after the challenges of the pandemic. For now, investors should build their strategy with this rise in interest rates in mind. An increase in rental prices can help maximize returns from existing properties in your portfolio, but it may be more expensive to buy real estate outright due to this increased interest or higher inflation rates. Investors looking for real estate options may consider alternative investments like DSTs or REITs versus direct ownership.
When evaluating your portfolio, it’s best to consider your overall goals, time horizon, and risk tolerance to determine what type of investment will be best suited to pursuing those goals.
About the Author: Drew Reynolds
Drew Reynolds is chief investment officer and head of research at Executed, a real estate technology company that provides Investment Property Wealth Management® to investors.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.
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