Rising interest rates were one of the biggest economic stories in 2022 and are slated to continue in 2023. As interest rates rise, the effects are felt throughout the economy – but are especially noticeable in real estate.
For generations, maintaining a real estate investment property has been a smart, lucrative investment. But rising interest rates are changing the real estate market and could pose risks to your rental properties or plans for real estate investment. What’s causing the rise in interest rates? How do interest rate increases affect the rental property market? And what do higher interest rates mean for real estate investors?
Why Are Interest Rates Rising?
Interest rates have been rising to combat the highest rate of inflation in the past 40 years. In 2022, high prices became persistent, the value of a dollar decreased, Americans’ purchasing power eroded, and the Federal Reserve took action by raising interest rates seven times.
Every time interest rates rise, the cost of borrowing becomes more expensive. Interest rate increases have blunted price increases, but the Fed wants prices to further stabilize or fall and has promised more interest rate increases in 2023.
Rising interest rates affect all sectors of the economy but have a particularly strong impact on the real estate market, rental properties, and real estate investors.
Rising interest rates affect all sectors of the economy but have a particularly strong impact on the real estate market, rental properties, and real estate investors.
1. Increased Demand for Units in Rental Properties
It’s a simple formula, and over the past year it’s proven true: When interest rates rise, mortgage rates do, too. Eventually, those higher mortgage rates push would-be buyers into the rental market.
In early 2022, an American could take out a $300,000 home loan at a 3.5% mortgage rate. Throughout a 30-year loan, the monthly payment would be $1,347, for a total payment of $484,920.
Now, the nationwide mortgage rate is about 6.5%. For a 30-year loan, the monthly payment would be $1,896, for a total payment of $682,560.
In one year, a typical buyer has seen the lifetime cost of a home rise by $200,000. No wonder homebuying sentiment is so low – rising interest rates have made purchasing a home too expensive for many Americans. People are instead likely to rent while saving money and waiting for mortgage rates to fall, which jacks up demand for rental units.
2. Higher Prices for Renters – For Now
Higher demand for rental units has meant that renters pay higher prices. Nationwide, median rent prices rose 6.2% in 2022 and 15% in 2021. Last year, higher interest rates likely contributed in part to those rent increases, as people elected against buying.
This year, rising interest rates may have a different effect, instead causing rent prices to stabilize. Rent prices have fallen for the past few months, which is normal in the fall and winter, but which may also be due to the Fed’s success in bringing down the rate of inflation by raising interest rates. Inflation makes everything more expensive and when it is reduced the cost of everything – including rents – tapers or decreases.
Continued interest rate increases in 2023 may tame inflation further, leading to lower rents nationwide.
3. Borrowing to Purchase a Rental Property Becomes More Expensive
Rising interest rates don’t only affect single-family buyers and renters. Higher interest rates affect real estate investors, too, starting with the increased cost of purchasing a rental property. Many investors use a 15-year mortgage. Over 15 years, the lifetime cost of a $1 million mortgage increases by $281,160 when rates increase from 3.5% to 6.5%.
Since the Fed started raising interest rates, the cost of purchasing a rental property has increased significantly, making it more difficult to get started as a real estate investor.
4. Rental Property Prices Taper or Even Decrease
Just as rising interest rates may eventually help stop runaway rent increases, interest rate increases may help taper or even decrease the cost of rental properties for investors.
Remember: The cost of taking out a loan to purchase a rental property has increased. Over time, that increased cost means reduced demand. With fewer investors able to buy, bidding wars for investment properties become infrequent, and sellers are likely to settle on more modest asking prices.
Plus, reduced inflation means tapered prices across the economy. If interest rate rises to curb inflation, the cost of investment properties is likely to taper or fall, too.
5. Investor Cash Flow From Rental Properties Falls
Real estate investors aim to establish a positive cash flow. Positive cash flow means generating more money from the property than is spent owning the property.
When interest rates rise, investor cash flow tends to fall. Mortgage payments increase with higher mortgage rates, and the cost of the materials and manpower to maintain a property rise with inflation faster than rents can be increased.
6. Real Estate Investment May Actually Become More Profitable
Cash flow may fall, but rental properties can become more profitable for investors as interest rates rise. Veteran real estate investors tend to measure instead by capitalization rate, which is calculated by dividing a property’s net operating income by the market value.
When interest rates rise, buyer demand and inflation should decrease, causing a property’s market value to fall. Net operating income should continue to rise, as rent prices increase over time.
For example, if one year ago a property was valued at $15 million and generated $700,000 in annual net operating income, the capitalization rate was 4.7%.
If after a year of rising interest rates, a property is valued at $14 million and earns $725,000 in annual net operating income, the capitalization rate is 5.2%.
All told, rising interest rates strongly impact rental properties and real estate investors. But it’s not all bad news: Rising rates mean people may have an even stronger need to rent apartments, homes, vacation properties, and other properties, making rental properties a smart investment.
