To be a successful real estate investor, it's essential that you understand interest rates and the impact they have on the value of investments. Interest rates are determined by three primary factors: supply and demand, inflation, and government monetary policy.
Supply and demand is generally the largest factor that influences interest rates. If lenders have more money to lend, or fewer borrowers are looking to borrow, interest rates will decline. Conversely, if lenders have less money to lend, or more borrowers are looking to borrow, interest rates will rise. Supply of credit in the economy is influenced by the amount of money banks have available to borrowers.
Inflation can have a significant impact on interest rates, particularly when the inflation rate rises substantially. Higher inflation rates will push interest rates higher. This is because inflation causes the real purchasing power of the face value of a loan to decrease over time, and a higher rate of inflation will increase the speed at which this occurs. Lenders will require a higher interest rate to offset this impact of inflation.
Federal monetary policy influences interest rates, by affecting the supply of money banks have to lend. The federal funds rate, set by the Federal Open Market Committee, is the rate that financial institutions charge one another for short-term loans. This rate in turn influences the interest rates banks sets on loans to individuals and businesses, including mortgages. The Fed influences the federal funds rate by buying or selling previously issued US securities. When the government sells securities to banks, the banks then have less money to lend, causing interest rates to rise. When the government buys securities from banks, the banks have more money to lend, causing interest rates to fall.
Despite the slow but steady recovery of the economy since the Great Recession, interest rates have remained near historic lows. As the economy continues to strengthen, it's inevitable that interest rates will rise, so real estate investors must understand the impact that rising interest rates will have on investments.
A higher interest rate on a mortgage or other bank financing option will increase the monthly payment of the loan, effectively decreasing the purchasing power of the borrower. In the absence of strong economic growth to offset the rising interest rates, this decreases the number of potential buyers for a given property, and can cause property values to decrease. However, if strong job and wage growth occurs alongside rising interest rates, the pool of potential buyers will remain the same despite rising interest rates, keeping property values stable.
For owners of large real estate investments such as mobile home parks or apartment complexes, rising interest rates can have a positive impact on profitability, despite the potential negative impact on property values. Higher interest rates will mean less potential home buyers can qualify for mortgages, leading to increased demand in the rental and low cost housing markets. So if you own an apartment complex, higher interest rates will indirectly increase the value of units in your complex, allowing you to charge higher rents. Similarly, if you own a mobile home park, rising interest rates can allow you to charge higher lot rents. So while rising interest rates maybe negatively impact the value of a property you own, increased demand in the rental or mobile home market will allow you to increase the net operating income of your property.
If you are considering buying an investment property, rising interest rates can provide a valuable opportunity depending on the source of funding for your investment. In an environment of rising interest rates, property values may decrease as competition from other buyers decreases due to the increased cost of financing. If your primary funding source for an investment is your own private capital, this can create a favorable situation because your purchasing power isn't tied to the availability or cost of financing. Similarly, if you are purchasing an investment property with private investment capital, seller financing, or another method that doesn't depend on bank financing, rising interest rates may benefit you.
Understanding the forces that influence interest rates, and the impact that interest rates have on property values is essential to smart real estate investing. Though rising interest rates can negatively affect property values, they can also increase the profit-generating potential of properties you own, and create valuable opportunities for investment.