Real Estate Investing and the Rising Interest Rates

Sister City Magazine | April 2003

By Alex Lisnevsky

All good things come and go eventually, and the same is true with the interest rates at the levels we haven’t seen since 1965. All of us know that the interest rates can’t stay this low for a long time, and most of the current homeowners took advantage of this opportunity to refinance their home loans and enjoy much lower payments while keeping the same or sometime increasing the size of their homes. So, what will happen when (not if) the interest rates finally start going up? Will the stock market recover in time to provide an alternative for cash exiting from real estate investments? Is the war with Iraq going to impact the state of the housing market? Are the talks about the "bubble" and the repeat of real estate recessions of the 80s and 90s going to prove true? How can somebody make money in real estate if the interest rates are higher than they are right now?

Let’s look at these issues, but let’s look at them with a clear mind, not in some kind of panic or doom and gloom frenzy that is so popular among some publications.

First of all, the rates are NOT going up soon! Very simply put, you still have a lot of time to get into or stay in the game and take advantage of mortgage rates at the historically low levels. Nobody expects that the interest rates are going up sharply for several months. At best, it’ll be a long process this will take many months and many meetings by the Greenspan’s team. The last meeting left the short-term interest rates intact as the Fed believed that the risks in the economy are "balanced" and the economy is finding its way to recovery. The main question on everybody’s mind is the possible war in Iraq and how it’ll affect the economy and the interest rates. Is the war going to be short-term or long-term? How is this war going to affect the oil prices and supplies? Is the war even going to happen? As these uncertainties continue, it’s unlike that the Feds will make any drastic moves until the situation becomes clearer.

The next Fed’s meeting is set for March 18; (The article was written in February 2003) however, even now most of the analysts predict that the Feds will keep the short-term interest rates at the same level. This short-term interest rate or "funds rate" is the rate that the banks charge each other for overnight loans.

Starting from January 2001, the Fed lowered interest rates 12 times. The last rate cut was done in November 2002, the only rate reduction of that year. The purpose of these rate cuts is to stimulate the economy: the lower the funds rate established by the Feds, the lower are the rates on mortgages, business loans, equipment and construction loans, which promotes more spending by consumers and businesses. Alternatively, the funds rates affect the interest rates the consumers get on their savings accounts, Money market accounts, CD’s and other passive savings instruments, which, in conjunction with the sluggish and unreliable stock market, forces the consumers to spend rather then to save money. The storm of mortgage refinances put a lot of money into consumers’ pockets while keeping their payments the same or even lower. Many consumers consolidated their debts, i.e. paid off their credit cards with increased home mortgages, however, those credit cards are not closed: they are just cleared and ready to be filled up again.

The economy is still working on recovery, and it’s going to be a long process. The $674 billion tax-cut proposal by Bush is waiting for the Congress to adopt. This proposal can have a significant impact on the state of the economy and on the real estate market. We’ll wait and see.

The higher interest rates are nothing new. Just short 12 years ago, in 1990, the average interest rates were in the 9’s. Imagine offering a mortgage to somebody right now at 9.5%? The borrower won’t even comprehend how can somebody in the right state of mind agree to such high interest rate. And yet, people made a lot of money in real estate in the 90’s and 80’s and many years before that, even when the interest rates were in double digits. Rates go up and rates go down; smart investors make money in high interest rate environment while not-so-smart investors loose money even when the rates go down. The rates alone do not guaranty the profitability of your investment portfolio; your sound investment strategy and business planning do!

Your strategy should look at the interest rate as only one factor in the equation of your success. Just like any business has variable and fixed costs of business, cost of materials and supplies, and other profit and loss categories, your investment business also has similar costs and expenses. The higher the interest rate, the higher is your cost of capital, which is no different than the cost of raw materials for a manufacturer.

Higher interest rates of mortgages might reduce the supply of homes on the market even further than it is right now: many homeowners will put off their decision to buy or sell their homes because they are sitting on a nice 30-year fixed mortgage at 5.5% while the new mortgage might be at 7.8%. So, they’ll choose stay in their house longer until they absolutely have to move. Higher interest rates will result in higher rents because the landlords will have to cover their PITI payments, and at the same time higher interest rates will make a home purchase less affordable to a larger segment of population who will stay in or re-enter the ranks of tenants. If the economy continues to grow strong and the unemployment remains low, there won’t be a shortage of reliable tenants who will be paying the market rents even when the rents are higher. These are just some of the market conditions that you can expect when the interest rates go north, and you should start planning right now how to take advantage of those and other conditions in the next two to five years.

As the interest rates climb higher, the investors must invest more time and money in learning to use all forms of available financing to their advantage and to have on their team a trusted financial adviser or mortgage broker who can help them find the best financial solutions. (I indicated a "mortgage broker", not a banker, because a commissioned broker is by far more interested and motivated to educate her investor client, while I’ve never seen any salaried bankers interested in spending time in educating their clients. That’s why even now, over 60% of all mortgages in this country are originated by the brokers, not bankers) Your success in real estate investing comes from a combination of the right property and the right terms of financing. It’s hard to make it work when only one of these components is right, and the other one is not.

It’s amazing home many real estate investors are not even aware of the uses and advantages of mortgages and financing tools outside of the scope of a 30-year fixed-rate mortgage. Learn to take advantage of negative amortization loans, short-term fixed and adjustable mortgages, seller financing, HELOC’s, bridge, cross-collateral, mezzanine and many other types of financing. Master working with the individual sellers to negotiate the best possible terms of seller financing either in the first or the second loan positions, wrap-around mortgages or AITD’s, lease-purchase agreements and other creative forms that are almost forgotten during the times of the lowest mortgage rates. For example, private seller carry-back loans can be negotiated at interest rates at the same level or often lower than the institutional loans for the same amount, however, one obvious plus of seller-backed loans is often forgotten: they don’t show up on your credit report, which makes your credit report lighter and increases your ability to mortgage more properties.

I have a client who was trying to convince me since the year 2000 that the market was going to tank any month now, and that she needed to wait until that time to buy a house. She was so convinced of her own prediction that she waited to buy until late 2002. She finally ended up buying a house that she could have bought two years prior for about half the price she paid in 2002. In the meantime, her commercial building that she bought in late 1999 without any hesitation or fears of falling market, grew in value 300% in the same time period.

As many people are afraid of higher interest rates and cooling market, there seem to be as many people out there who can’t wait for it to happen. There is no such thing as bad market. There are bad investment strategies that will fail even in good markets.

Depending on your overall investment strategy and your previous experience and your future goals, you might choose to concentrate on fixer properties, foreclosure sales, condo conversions, new construction, or multi-family buildings. If you are an expert in mobile home parks, you might continue to concentrate on this segment, because it’ll grow as a viable option for affordable housing. Condo conversion projects will continue to be a feasible source of new affordable apartments barring any local restrictions, such as rent control, overzealous local legislators, and so on. Some investors became quite successful in buying a small property on an oversized lot and then building additional units or increasing the square footage of the property, thus successfully increasing the value of the property without the additional cost of land. The deals are always there, you just need to look for them and make sure you are ready to act fast when this deal comes your way.

I never liked negative cash flows. I never bought a property that had a negative cash flow, however, in the last several years, I came across many investors who were buying their properties with a maximum leverage and paid for the negative cash flow sometime for several years, yet came out better off in the end due to fast-paced appreciation of their properties. I consider those investors successful "despite themselves". Many got so successful with this strategy that they now take this appreciation for granted. That’s dangerous philosophy, the same philosophy ruined many stock portfolios just two years ago. Nobody knows which way the property values are going to go, and the voices of real estate gurus are divided: some of them predict the prices to continue going up, while the other ones predicting doom and gloom across the board. Don’t listen to them, do your own research and make your own assumptions.

In the times of rising rates and flattening market, the smart investors will have to go back to the fundamentals of real estate investment and buy properties that produce positive cash flow, have fundamentally sound financials, and have solid prospect of growth of values NOW, not some seven years from now. Remember, with any type of investment, you make money not when you sell it, but when you buy it! The investor is going to concentrate on the areas and the types of properties that are truly in demand rather then any property that looks cheap. For example, independent hotels are a loosing market unless they are part of a solid franchise chain, or unless they have a killer location. However, a sound residential apartment building might be an excellent investment opportunity given a decent location and financing. Look at the cap rates and the gross rent multipliers, look at the vacancy factors, research the employment situation and the economic prospects for the area, any major developments that might affect the value of the area for the prospective buyers or tenants, check out the new construction of residential and commercial projects, took to the builder reps about the interest in the projects from prospective home buyers or commercial tenants. All this research will give you by far more ammunition for your real estate investment strategy than the mere fact that the interest rate for your mortgage is going to be below 5%.

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Rising interest rates are nothing to worry about it. It’s just another cycle in the economics of the real estate investing. The less time you spend on worrying about the interest rates and the more time you spend on planning your investment strategy and putting the right components in the right places, the more successful you will be in any cycle of the market.