Investing In Real Estate During High Interest Rate Periods

Some investors might see a rise in interest rates as a reason to hold off on investing in a property. However, investing in real estate in a rising rate environment can be good. People will always need housing, and even if the market conditions aren’t ideal, people will need to rent out a home or apartment.

Interest rate hikes can allow investors to make more money because of the increased demand for rental properties. When there is urgency on the market, renters are willing to pay more because they don’t know how much longer a space will be available. Read on for three tips you can reference if you’re looking to invest as interest rates rise.

Understanding the Role of Central Banks

Interest rates and their fluctuations are not random. The central bank of the United States, more commonly known as the Federal Reserve or the Fed for short, plays a key role in determining interest rates. We’ve experienced higher rates lately because of specific and highly calculated actions taken by the Fed.

A key function of the Fed is establishing the Federal Funds Rate (FFR). This is the rate the banks and credit unions can charge for lending money to other banks and credit unions. The Federal Open Market Committee (FOMC) is a branch of the Fed responsible for reviewing, managing, and making changes to the FFR. The FOMC meets a total of eight times a year and decides whether any changes to the FFR are necessary and how drastic the change should be.

The FFR is often used as a guideline for banks or credit unions when they’re deciding on their own interest rates. When the FFR goes up, banks and credit unions typically follow suit and increase their prime rate. Since it would now cost more to borrow money, banks and credit unions want to be compensated accordingly and maintain profitability. Generally, the prime rate is the current FFR plus an additional 3%. The higher the FFR goes, the more expensive it will be to purchase a home and the harder it will be to get approved for a mortgage.

It’s essential to understand why the Fed would ever increase the FFR. After all, when this happens, it greatly increases the amount of interest that borrowers will owe. The primary reason is to slow down the economy for a period to help address inflation. By making it more expensive to borrow money, people and businesses spend less, which can help prevent prices from rising too quickly. When spending cools off, and the economy stabilizes, the rates can slowly start to be lowered again.

The recent COVID-19 has caused worldwide economic instability, which forced the Fed to take fairly severe actions. Starting on March 16, 2022, the FOMC began raising the FFR to curb skyrocketing inflation. The rate change started slow but picked up in the late summer and fall of 2022. The FOMC decided to raise the rate seven times in 2022, starting with a rate of 0.25% in March and ending with a rate of 4.5% in December. In 2023, inflation started to cool down, and there were only four rate hikes. The largest came on July 26, 2023 and increased the FFR to 5.5%.

The timeline for the hikes and the decreased value for each one paints an optimistic picture for the future. As we move further from the pandemic and inflation starts to slow down, FFR increases will likely stop. However, there may still be a few required in the future, and that doesn’t necessarily mean the current rates will decrease. Experts predict a lower rate by the end of 2024, but it could be a long time before we see a pre-pandemic FFR again.

How Does High Interest Impact Real Estate?

When the Federal Reserve increases rates, the market sees a huge impact. Properties get more expensive. Therefore, the overall demand from homebuyers who may have been looking previously decreases — they are less able to afford the average property.

More buyers are priced out
Demand falls
Supply falls
Long-term impact depends on the growth of the overall economy

More Buyers Are Priced Out

Interest rates for average 30-year fixed mortgages went up to 7.42% as of September 7, 2023, an increase from 7.32% the week prior. It’s a significant increase, as rates were last at this level in December 2000, prior to the September 11 attacks.

As a result, many interested homebuyers are in full retreat and no longer looking for properties throughout the national housing market. Rate increases mean homebuyers will have to pay more each month on their mortgage and have less power in real estate dealings.

This means their pre-approval amounts decrease, and any buying power they thought they had is diminished. As a result, buyers must use more of their savings to account for the increase or forgo homebuying altogether.

However, a rise in mortgage rates also causes a rise in people looking to rent out homes because they have limited options. For savvy investors, this represents a potentially profitable opportunity.

Demand Falls

The demand for homes is lower when interest rates rise, which is what the Federal Reserve wants to happen. To maintain a stable market, increase affordability, and have lower interest rates in the long run, the Fed has to increase the figures from time to time.

So, what does this mean for buyers and investors? With less demand for homes, investors may be wary of stepping into the real estate market, and buyers must either pay the price or wait until the Federal Funds Rate goes down and the market is more favorable.

Supply Falls

During high-interest times, there will also be a lower supply of homes on the real estate market. Without much demand, sellers may forgo listing their properties until the market is more favorable. This means investors will have less to choose from and may spend more on a home than they would in a lower interest rate environment.

Long-term Impact Depends on the Growth of the Overall Economy

Economic growth plays a major role in how high inflation affects our communities. When the economy is thriving, there will be more goods in circulation and, therefore, less inflation. Put simply, the more money spent, the better the chances are of the Fed keeping interest rates down.

3 Tips for Investing in Real Estate in High-Interest Times

So, you want to invest in real estate despite market volatility? This certainly isn’t impossible, and you may be able to find success using some of these tips to inform your investment strategy.

Buy if you can
Consider a long-term strategy
Utilize ARM and short-term loans

Buy If You Can

Higher interest rates will result in higher borrowing costs. This will price many buyers out of the market and result in less demand and possibly lower prices. It could be a worthwhile investment if you can afford to purchase a property during a time of high interest rates. Many home sellers will be trying to get their homes off of the market with no luck due to the lower demand. If you have the funds available, you may be able to negotiate a lower asking price by making a competitive offer (ex: cash, no contingencies).

You can also consider increasing your down payment amount. A higher down payment means less risk for the lender. This will help you secure a lower interest rate and avoid paying private mortgage insurance, which will lower your monthly payment and save you on interest in the long run.

One factor that will always remain true, even during tough market times, is that people will always need a place to live and property values have historically bounced back and increased after economic downturns.

Consider a Long-Term Strategy

Compared to last year, American homebuyers have lost about $7,000 in spending power because of inflation, corresponding with an interest rate climb to above 7.4%. With market volatility making buying difficult, many people will opt for renting because it’s what they can afford. As an investor, this presents a unique opportunity for you.

Purchasing a rental property can allow you to yield high returns, especially if you decide on a long-term strategy. Borrowing money becomes more expensive when the Fed raises rates, and the demand for rental homes and apartments will increase as many prospective homebuyers will struggle to qualify for a mortgage, and will need to resort back to renting. A rental property in the right neighborhood can be a great investment that can increase in value over time and help you hedge against inflation.

Investing in a home or apartment can help you take advantage of the current increased rental demand. However, you could also consider investing in commercial real estate, like duplexes and multifamily lots. In South Florida, we have seen increased interest from both domestic and international investors towards investing in multifamily projects, particularly in affordable neighborhoods, so they can obtain guaranteed rates through Section 8 programs and help satisfy the need for affordable housing.

According to Zumper's latest rental market trends, the median rent price in Miami is 64% higher than the national median. Here is a look at average rent in Miami, FL broken down by property type as of May 2024:

$2,680 per month for an apartment
$3,250 per month for a condo
$3,500 per month for a singe family home

When broken down by property type, houses in Miami are more expensive to rent, with condos not falling far too behind.

Take Advantage of ARM and Short-Term Loans

You might also want to consider financing options like an adjustable-rate mortgage. An adjustable-rate mortgage (ARM) has a variable interest rate. Variable interest rates fluctuate over time and are based on a benchmark interest rate or index.

With an ARM loan, the starting interest rate will fall below the market rate and will be fixed for a set period of time. After that fixed-rate period, the rate will float and adjust on a routine basis based on the current market rate.

As a real estate investor, an ARM loan can be a great option if you want to secure a lower interest rate for a fixed period of time, and gain some predictability with your payments. This is especially lucrative for investors with a short-term fix and flip strategy, as you aim to sell the property before the fixed-rate period ends. You can also use an ARM loan towards a long-term strategy and refinance the loan for a fixed rate mortgage in a few years once interest rates cool down.

Below are some examples of adjustable-rate mortgages

Hybrid ARMs. A hybrid adjustable-rate mortgage, also referred to as a fixed period adjustable-rate mortgage, is a combination of a fixed-rate mortgage and an adjustable-rate mortgage. After the fixed interest period, the interest rate shifts to adjustable. The most common hybrid ARM is 5/1, which means five years fixed and then an adjustable rate that resets yearly.
Interest-only ARMs. An interest-only ARM is an adjustable mortgage where you’d only have to make interest payments for the first period of the loan, so you wouldn’t need to pay down the principal until later. Interest-only payments can be for a fixed time or the loan's entire life. The latter means you’d pay your principal in one lump sum at the end. Please note you aren’t building equity during the interest-only period, so your payments will increase when it’s over.
Payment option ARMs. A payment option ARM provides the buyer with several payment options to choose from, such as a 30 or 40-year amortizing payment, an interest-only payment, or a minimum payment, among other options.

You can also take advantage of a short-term loan from a portfolio lender, commonly known as a bridge loan. A bridge loan can be used as a short-term solution to finance your investment property as quickly as a cash offer. The application process for a bridge loan is streamlined and requires minimal documentation, allowing you to receive funding in less than 10 days.

Rates for a bridge loan in 2024 are ranging between 10.5% and 12% and can be fixed or variable. These are interest-only loans with a balloon payment due at maturity. This is a viable option for real estate investors who want fast access to capital and a lower monthly payment.

Bridge loans are short-term loans ranging from 1-3 years. As an investor, if you decide to use a bridge loan, it’s important that you have an exit strategy in place so you have a plan on how to pay off the loan at maturity. Common exit strategies include:

Refinancing the loan
Selling the property
Using income from other ventures to pay off the loan

With so many financing options available, you can still invest in real estate during times of high inflation. You just need to have an investment strategy and align yourself with local real estate and mortgage professionals who can help set you up for the long haul.

Consultation and Financial Planning

Investing in real estate can be a successful venture, even when dealing with high interest rates. Remember that the real estate market has weathered high Federal Funds Rates before. For example, the FFR hit an all-time record of 20% in March of 1980, yet properties continued to change hands, and mortgage payments were made.

However, when interest rates are higher than usual, the margin for error considerably shrinks. In such times, going it alone is a bit more risky and seeking the expertise of qualified financial experts becomes especially valuable. These professionals can offer guidance based on their deep understanding of the market and its dynamics, helping steer your investment strategy in a direction that maximizes potential returns while mitigating risks.

A crucial first step is to work with a knowledgeable mortgage broker. They help you secure the best possible interest rate for your mortgage. Even seemingly small differences in rates can result in substantial savings over the lifespan of a mortgage. For example, reducing your interest rate from 5.25% to 5.2% might seem insignificant, but over time, this small decrease can add up to significant financial savings.

Mortgage brokers typically have a wide network of lenders and are familiar with the intricacies of the lending market. These local lenders often demonstrate a higher risk tolerance than larger, traditional, big-box lenders. Their intimate understanding of the local market dynamics allows them to envision the potential value of an investment more easily than more conservative lenders with a border and more generalized focus.

Using the right financial advisor can also provide a more comprehensive look at your personal finances. These experts analyze the details of your finances, such as income, credit score, and debt-to-income ratio (DTI), to determine whether purchasing a particular property is a wise investment decision. Not only that, but financial advisors can offer tips for stock market investing and diversification as well as make recommendations like using dividend-yielding assets (REITs) to bolster your financial situation.

You might be an expert in your niche or industry, but it’s always a good idea to rely on experts in financial planning to ensure you make the right decisions going forward.

Setting Clear Investment Goals

Perhaps most crucially, make clear, wise investment goals to help guide your day-to-day decisions. If you want to maximize your profit in the short term, for example, the best decisions will be drastically different from trying to build up a portfolio you can live on in your retirement.

When dealing with a constantly shifting market amid high interest rates, it’s important to rely on numerical analysis to help determine the overall profitability of a property. For example:

Cash Flow: A positive cash flow is ideal for any real estate investment. This means that after all expenses (like mortgage payments, taxes, insurance, maintenance, and vacancy costs) are deducted, you're still making a profit. For example, if your rental income is 1,500 per month and your total expenses come to $1000, you have a positive cash flow of $500 per month.
Cash-on-Cash Return: This measures the return on the actual cash invested, providing investors with an accurate analysis of their investment's profitability. A good cash-on-cash return is typically in the range of 8% to 12%. This means that if you invest $100,000 in cash for a property, aim for an annual return of $8,000 to $12,000.
Return on Investment (ROI): This is a measure used to evaluate the efficiency or profitability of an investment. A good ROI for real estate investment varies significantly depending on the type of property and the market, but many investors aim for an ROI of 10% or more.
Debt Service Coverage Ratio (DSCR): This ratio compares a property's annual net operating income to its annual mortgage debt service, helping investors assess the property's ability to cover its debt. A DSCR of greater than 1 indicates that the income generated by the property is sufficient to cover its debt obligations. For instance, a DSCR of 1.2 would mean that the property's income is 20% higher than its annual debt service.
Loan to Value (LTV): This is a financial term used by lenders to express the ratio of a loan to the value of the property purchased. A lower LTV is typically more desirable because it means you have more equity in the property relative to the debt. Most lenders prefer an LTV of 80% or less, meaning that the borrower should have at least 20% equity in the property. This reduces the lender's risk in case the borrower defaults on the loan.

Another key investment strategy is to use more cash to increase the down payment. Quite simply, the more cash you use, the less money you’ll need to borrow, and the less of an impact high interest rates will have in the long term.

This strategy can make you more attractive to private lenders. With the right private lender, you could find a short-term, interest-only loan when you offer 50-65% financing. Interest-only loans can keep your operating expenses low while you improve the property and wait to sell for a profit or refinance for a longer-term loan when rates drop.

While the market might be slow and the costs of investments are high, you can still take several proactive measures to position yourself for future investment opportunities. For example, paying off high-interest debt, such as credit cards, can improve your financial health and increase your borrowing capacity. You could also opt for using cash more often to prevent taking on additional debt and keep your financial situation stable. It’s also a good time to spend less in general and build up the future down payment that you’ll be making so you can reduce how much you’ll need to borrow.

Once you have your goals, you can purchase properties, rent them out to tenants, and even consider living in one of your rental properties alongside your tenants, depending on what works for you.

Final Thoughts

Are you considering investing during high-interest times? You could have some luck here and achieve a significant return with the proper approach. As mentioned previously, high interest rates are not necessarily a reason to step out of the market. Interest rate hikes can allow investors to take advantage of having fewer buyers in the market and increased demand for rentals.

A rising rate environment doesn’t need to slow you down. People will always need housing, and even as we approach an economic downturn, real estate has historically bounced back and increased in value over time.

How Vaster Can Help

So whether you’re looking to close on your next investment property via financing or are interested in learning about commercial loans so you can invest in a multifamily lot, we’re here to help.

We’re backed by two of the best real estate firms in South Florida, which means we can provide you with the best-in-class service. Ready to discuss your options? Get in touch with us today.

Sources:

Does Growth Cause Inflation? | Cato Institute

Federal Funds Rate Definition | Investopedia

What The Fed’s Fourth Rate Hike This Year Means For Housing | Bankrate

Explaining Rising Interest Rates and Real Estate to Clients | Investopedia

How Interest Rates Affect the Housing Market | Investopedia

How to Invest for Rising Interest Rates | Investopedia

5 Benefits of Real Estate Investing in a Rising Interest Rate Environment | Greystone

Variable Interest Rate Definition | Investopedia

Is a Rental Property a Good Investment in 2022? | BelongHome

Latest mortgage news: Rates at fresh high as borrowers pull back | Bankrate

The Average American Family Has Lost $7K in Spending Power, Thanks to Inflation | Yahoo! Finance