Inflation is rising, and the Federal Reserve is halfway through a full year of raising interest rates to combat it. The average 30-year mortgage rate is already up more than 2% this year, from 3.24% to 5.28%.
When interest rates rise, real estate prices tend to fall. It is a basic fact of supply and demand. When it costs more to borrow money, property buyers cannot afford to bid as much. Eventually, many buyers are driven out of the market altogether, and supply outstrips demand, causing prices to fall.
But what does that mean for your wallet? In the short term, that means pain. But this could all be paper losses if you stay patient and focus for the long haul.
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1. Not much in the long run
As long as you have a good long-term loan and a low loan-to-value (LTV) ratio, short-term drops in real estate prices can raise blood pressure, but they don’t really matter in the long run.
Let’s say you bought a home with a 30-year mortgage eight years ago and have since moved in and are now renting it out. Your LTV is 60%, and your price is fixed for the next 22 years. If the property’s market price drops, it shouldn’t change anything for you. Rents tend to stay steady even in bearish real estate markets (all those buyers who were once forbidden to buy should be renting), and you’re not trying to sell the house.
At Motley Fool, we love to talk about how short-term losses aren’t real losses until you sell the stock. If you stick with it, the investment may turn out eventually. The same is true for real estate investments.
If you don’t have a friendly debt position (such as an adjustable rate, high lifetime value, or short term), you may be on your way to some drama. Banks begin to get nervous when your mortgage value goes up and your loan rating may be lowered. If you’re ready for renewal and additional value lockers, getting a new loan can be more difficult. Not to mention, it’s possible that by the time you need to renew the loan, the rates can be twice what they were when you started the loan.
If this is the case, buckle up and do whatever you can to make it work. If you need to bring in more equity or shop for a new lender at lower rates, do it. It is likely that you will be able to refinance again in the future and get a better deal. The key is to stick with the investment for the long term. Let the tenant make debt payments and help build your fortune.
2. Some of your real estate investments may be fortified
If you have boosted your commercial or residential real estate portfolio through real estate investment trusts, or REITs, you may have a certain level of immunity from interest rates. REITs buy and manage real estate at a much higher level than individual investors and have more resources to hedge interest rate risk.
A good example of this is real estate investment trusts that make or buy real estate loans with borrowed money. They often match short-term financing with long-term purchases. This can cause a problem when interest rates rise and their short-term papers need to roll over at interest rates that are now higher than the return on their long-term investments.
Management at many mortgage funds have revised their strategy in the past five or 10 years as interest rate concerns have mounted. Some REITs have hedging programs that pay off when interest rates rise. Some invest in adjustable rate mortgages so that their returns increase along with the rates. Some focus on short-term investments.
If you own REITs, take some time to learn about the management team’s plan to deal with price hikes. Do they have a hedging program or other strategy? If you are not satisfied, consider replacing the investment with a new REIT.
3. Your other investments will also be affected
When interest rates rise, the stock market tends to fall as well. Companies have difficulty obtaining financing for new projects and growth. Investors are beginning to allocate cash to fixed income investments that now enjoy higher returns. The spigot of easy money that was flowing directly into the stock market is closed.
Unfortunately, all of this means that you probably won’t be able to turn to your stock portfolio if your real estate portfolio crashes. Of course, if you take the long-term view that we’ve discussed, you’ll still be fine in the long run. Keep a good amount of dry powder (cash) ready for opportunities, and grab them when the market crashes. But only sell your investment if the premise has really changed and the business model is no longer viable.
Remember: you’ll be fine in the long run
Investors waste a lot of time worrying about possible crashes in the future. And if your investments are overleveraged or in poor shape, you may need to set aside some reserves. Otherwise, your best bet is to keep investing. As Warren Buffett likes to say, “Be afraid when others are greedy, and be greedy when others are afraid.” In other words: buy when there’s blood on the streets.