Rising Interest Rates Effect on Real Estate

by Christopher Levarek

“The place is here, the time is now, and the journey into the shadows that we’re about to watch could be our journey.”

- Rod Sterling “The Twilight Zone”

If you are familiar with the show, “The Twilight Zone”, the quote above will obviously bring back childhood memories of what was a very successful sci-fi mystery series which aired from 1959-1964 and then again from 1985-1989. The magical bit about the series was that it did an amazing job showcasing alternate realities or potential unexplained phenomena which got the audience wondering, “What if this really could happen?”.

Even if you’ve never watched the series, you might just feel like we are living an alternate reality today. In fact, if I were to start a made-up Twilight Zone show based on today, it might go something like this.

“The year is 2022 and world is on the brink of disaster. Gas prices are near $5 a gallon, energy costs have doubled, interest rates are at 9% and the world is at war.”

Of course, everything mentioned in that headline above is true albeit with a spin for “headline grab-iness”. Yet, all is not lost and nothing is really on the brink of disaster even though it might seem that way.

For real estate investors, the most obvious indicator of our economy is interest rates and they’ve been rising. In fact, a 30 year mortgage in January of 2022 was at 3.22% fixed while in October the same loan would be around 7.22% fixed.

That’s no joke for investors.

Today we look at the rising interest rates effect on real estate and investors. Let’s jump in.

Rising Interest Rates

As many of us own a house or have borrowed money at some point from a lender, we are all familiar with the concept that if the rate of our loan goes up, we pay more. So if rates go up on money we borrow for investment, the cost or debt service expense goes up.

Now as an investor, this isn’t good. We like keeping our expenses low and our income high, as this equals more cashflow. Seems obvious enough right?

Let’s breakdown just how much has changed for 2022 in an example below :

Jan 2022 : Investor Bob buys a $300,000 single family rental in January 2022 with the following numbers :

a 30 year mortgage at 3.5% for $240,000
His monthly payment is $1078
It Rents for $2500 a month.

Bob now cashflows $1047 after putting 15% aside for other expenses.

$2500 - 15%($2500) -$1078 = $1047

NoW let’s look at if bob bought the same property today with today’s rates :

October 2022 : Investor Bob buys the same $300,000 single family rental in October 2022 with the following numbers :

a 30 year mortgage at 7.76% for $240,000
His monthly payment is $1722
It Rents for $2500 a month.

Bob now cashflows $403 after putting 15% aside for other expenses.

$2500 - 15%($2500) -$1722= $403

Alright so Bob, the investor, ends up paying $600 more for his debt costs. Thus his cashflow goes down. Simple enough right? So what’s the result for real estate?

Rising Interest Rates Effect on Real Estate

A few things become quickly apparent in the simple example above. Number one is that Bob is not happy and number two is that Bob is in no hurry to buy more real estate. Yet, these simple rising costs have a far greater impact on the real estate market then just on Bob. Let’s look why.

Like many other industries, if costs go up, the margin or profit goes down. So in real estate if the cost to purchase real estate and make a profit goes down, less investors buy real estate. Coincidentally enough, as costs go up for homebuyers, less homebuyers buy homes.

Due to the lack of transactions and increased debt costs, real estate is therefore not renovated nor improved as frequent. Why bother fixing up the property if it won’t sell?

Another effect of course is on the development of real estate. If the costs to borrow to build become to high for a developer, they will not build.

Another effect is that capital now flows into alternate investments providing a more lucrative return with a larger margin.

To summarize then, the effects of rising interest rates are :

Real Estate transactions go down or halt
Real Estate development goes down or halts
Real estate renovations go down or halt
Real estate prices fall (eventually)
Capital flows to alternate investments

What Does It Mean

The above five effects of rising interest rates all have meaning. Depending where you sit with real estate, you are most likely affected to some degree. Yet, I will outline the issues with these effects for many :

Decrease in transactions
- Forces many investors or real estate professionals out of the industry. Sellers are forced to wait for months, if not years, for a sale.
Decrease in development
- An already undersupplied housing market is further capped or restricted. Lower supply equals rising rents and rising house prices(inverse to what’s expected).
Decrease in renovations
- Leads to under maintained properties and slumlord mentalities to save costs.
Decrease in Housing Prices
- Homeowners and investors lose equity and potentially property.
Capital Flows to alternate investments
- This includes flowing to big corporations, international economies, etc. Again slows down any positive change for affordable housing without funding.

IN FINAL

So as you can see, the rising interest rates effect on real estate is very real!

In fact, the shock of the rising rates will be felt for 3-5 years at the least. In order to curb inflation, the Federal Reserve is crippling the economy in many ways and real estate is just one.

Yet, it is worth noting, we’ve been here before and we’ll cycle back through to higher highs. I’ll leave you with one last thought of encouragement. In 1980, interest rates were at 18% at their peak.

There is still a lot room to go and opportunity to invest.

With that, Happy Investing and catch you in the next article!