By Drew Reynolds
Choosing an investment strategy isn’t something that happens in a vacuum. Along with their personal investment goals and risk tolerance, investors need to consider the current state of the economy and how this will affect returns moving forward. Unfortunately, given the often unpredictable nature of the market — with its supply chain issues, rising inflation that may be more than transitory, and labor shortages, among other challenges — it can be difficult for investors to decide what course of action to take 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 typically can provide the potential for positive returns as property values tend to move upward over time, interest rates are a part of the investment equation that all investors — particularly those interested in owning investment properties — will need to take into consideration.
How are interest rates changing?
Mortgage rates dropped to historic lows during the pandemic. These rates remained at a low point throughout 2020 and 2021, which led to a very competitive real estate market and sent demand for new properties soaring given historically low borrowing costs.
However, things have started to change as we move through 2022. Mortgage interest rates have moved upward at a sharp pace. The average rate for a 30-year fixed mortgage hit 3.5% in the last week of January, making these the highest mortgage rates we have seen since the pandemic started.
The Federal Reserve expects to raise short-term interest rates throughout 2022. These rate increases are consistent with ongoing economic growth, which is also triggered by inventory shortages due to supply bottlenecks. They are also intended to combat the current spike in inflation, which remains one of the Fed’s key mandates. Higher interest rates will dissuade consumers from taking out loans, which will slow the economy down and eventually curb inflation. Both investors and would-be homeowners will need to prepare for these ongoing changes until the economy levels out by budgeting for higher interest rates when making investment decisions for properties.
What do interest rate changes mean for real estate investment?
These rising interest rates will affect each investor differently depending on their personal strategy. Investors who are planning to sell can potentially expect strong returns, but buyers will likely find themselves paying more. Additionally, for investors who wish to sell their investment properties, there are extra considerations for where to invest those proceeds.
Home prices are not expected to drop in 2022, although growth will slow as last year’s red-hot market cools off. Right now, home prices are estimated to grow approximately 7.5% this year, which means that investors looking to buy new properties are going to continue facing high purchase prices.
Rising interest rates increase the cost of borrowing money and can make monthly payments less affordable compared to borrowing during a time period 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 or her 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. This represents $108 a month, for 12 months a year, over the course of a 30-year loan – that 1% difference in interest rates can quickly add up, and for investors needing more than $200,000 to purchase an investment property, that difference in interest rates will feel greater.
In the short term, these increasing interest rates can make purchasing new properties more expensive, but that doesn’t mean there aren’t options for investors who want to purchase real estate in the current environment. Between rising interest rates and increasing property costs in competitive markets, some investors have been turning to Delaware Statutory Trusts (DSTs) as potential investments. Investing in DSTs can provide fractional ownership into commercial real estate properties that may not be typically accessible 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 multifamily, self-storage, or distribution centers to name a few. If these properties offer shorter lease terms, i.e., multifamily or self-storage, they can potentially offset higher interest rates by increasing rent prices versus properties that offer longer-term leases like NNN properties. For investors looking to purchase large-scale residential or commercial properties, they will want to focus on properties where rental increases are an option during this time.
For investors who already have real estate in their portfolio and the option to adjust the rent, rising interest rates can actually be a good thing. Multifamily residential properties and hotel properties are two examples of properties that offer this option. The investor’s mortgage rate may stay the same (depending on whether they have an adjustable or fixed-rate mortgage), but they can make more from the property with increasing rent prices. In August 2021 alone, rental prices went up 10 percent across the country. By having the ability to update monthly rents as the end of a short lease term (every 12 months or so) and the ability to update rates daily in hotels, an investor can adjust their rental prices to reflect current market pricing more so than an investor who has a long-term commercial lease property.
How do real estate investments behave in an inflated market?
Despite the recent increase in interest rates, real estate still serves as a hedge against inflation because it doesn’t always move in ways that are correlated to 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 Q3 2020 – Q3 2021, annual GDP growth and inflation rates were 4.9% and 5.4% respectively, while according to the NCRIEF Property Index, private real estate posted a 12.1% annual rate.
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 these rising interest rates in mind. An increase in rental prices can help maximize returns for existing properties in your portfolio, but it may be more expensive to purchase direct real estate as a result of this interest increase or rising inflation rates. Investors looking for real estate options can consider alternative investments like DSTs or REITs compared to direct property.
When evaluating your portfolio, it’s best to review your overall objectives, time horizon and risk tolerance to determine what kind of investments may work best to pursue those goals.
About the author: Drew Reynolds
Drew Reynolds is Chief Investment Officer and Head of the Research of Realized, a real estate wealthtech firm that provides Investment Property Wealth Management® for investors.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.