One of the greatest benefits of a low interest rate environment is that the cost of borrowing money is cheaper compared to a high interest rate environment. A low interest rate environment can be an encouraging time for real estate investors. It is often during these times when first time real estate investors take the plunge and purchase their first rental property.
People feel more confident to get into the real estate investing game because payments generally can be lower in a lower interest rate environment. If an individual has a variable rate on a mortgage, this rate is linked to the Central Bank’s prime lending rate. As such, when the prime lending rate is low, or is decreasing, so too is the rate on the variable rate mortgage.
Despite the great benefits, low interest rate environments can also be very dangerous to novice investors. Since people feel confident to buy rental properties in low interest rate environments, they sometimes forget to take into consideration a number of important variables.
For instance, when interest rates start to rise, the investor has to make sure that they are able to financially survive the rise in rates, thus continuing to meet their payment obligations.
There are a number of ways that a real estate investor can exercise due diligence in order to avoid disaster in a rising interest rate environment. Here are some of the ways:
1) Buy for Strong Cash Flow
Whenever a real estate investor purchases an investment property, they must make sure that they have a positive cash flow being generated from the property each month. Therefore, as interest rates rise, and if the investor is in a variable rate mortgage, they should be able to withstand the increased cost of their mortgage payments. In short, the investor should still be generating monthly cash flow from the property, even after interest rates go up. If the investor finds himself or herself in a position in which they are not generating monthly cash flow after interest rates go up, then they are not in a good position. This concept of testing the future cash flow of a rental property, once interest rates rise is referred to as…
2) Stress Testing Your Portfolio
Stress Testing your portfolio is the act of calculating current payments on your rental property today, and determining today’s cash flow. In addition to determining today’s cash flow, the investor would also calculate the cash flow on their property, by using inflated numbers for their interest rate. The inflated numbers used, should represent the figure in which the real estate investor believes interest rates will rise to. By doing this exercise, the investor will be able to easily determine how much they are cash flowing their rental property today, and how much they would be cash flowing the property in an increased interest rate environment. Other than buying for cash flow, this is one of the most important activities a real estate investor can take when running their numbers in order to determine if the rental property is a good buy.
Here is an example of how to stress test your portfolio. Let’s say for instance that you are planning on buying a rental property valued at $100,000. The mortgage that you will have on this property is $75,000. The interest rate for this mortgage is 5%, you are going to make monthly payments of $436.21, and the mortgage is amortized over 25 years. The property taxes on this property equal $100/month and the property insurance is $25/month. The monthly rent that you collect is $1,000/month. If we add up all of our monthly operating expenses for the property ($436.21 + $100 + $25) this equals a total monthly operating expense of $561.21. Therefore, if we take our monthly rent of $1,000 and subtract our monthly operating expenses of $561.21, we get a figure of…$438.79 monthly positive cash flow. This is a good thing, as we are in a strong positive cash flow position.
If we believe through credible sources that interest rates are scheduled to go up over the next few years by 3%, we need to run new numbers. We need to now calculate what our monthly operating expenses would be on the property if the interest rate rose to 8% (5% + 3%). Therefore, the value of our property is still $100,000. The mortgage amount is still $75,000. The interest rate is now 8%, which means that our monthly mortgage payment on the property is $572.42. Our revised figure now for our total monthly operating expenses is ($572.42 + $100 + $25) which equals…$697.42. Therefore if we now take our monthly rental amount of $1,000 and subtract $697.42, this gives us a new figure of… $302.58. Therefore, we now know that if interest rates rise from 5% to 8%, we will still be cash flowing this property monthly. Therefore, we know that this is a good purchase, and if interest rates do in fact rise, we will not find ourselves in a compromising financial position.
3) Have a realistic idea of the future trends of interest rates
Most people live in a state of paranoia. They buy into all the negativity that the media feeds them. One day they might hear on the news that interest rates are anticipated to be on the rise. With this news they become scared of the potential financial consequences that may result. Further, they become so scared, that they take no action and end up doing nothing at all. This happens all the time, and I often witness this on a daily basis. The good news is that there is a solution to this. The solution is to only listen to credible sources. Don’t just listen to the news and advice from uneducated people or questionable sources. As a result, in this particular case, the best people that would have a pulse on the future trends of interest rates would be Economists, top Mortgage Brokers, and Central Banks. These are credible sources. Pay close attention to what these individuals and institutions are saying. Compare and contrast the information from these sources. If you do this, you will be much more educated than the average person regarding the future trends of interest rates.
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