Inflation is slowly rearing it’s ugly head, and with it come higher interest rates. Despite the obvious potential for downward pressure on prices. Rental property owners actually have reasons to cheer on rising interest rates provided that the economy is steady!
Home buyers obviously don’t like seeing interest rates rising, unless they’re lucky enough to already be in a transaction with a mortgage rate lock. It makes homes less affordable and forces decisions about buying less of a home or continuing to rent. Those potential buyers who are saving for a down payment or working on repairing their credit are at risk of rising rates during their preparation.
The home buyer perspective is pretty simple, the lower the interest rate, the lower the payment, and the more I can get for my money. When rates fall, it definitely spurs home buying. But, rates have been historically low for years now and the housing market has only experienced what many would call a weak recovery. When rates rise, it certainly doesn’t help, a glass half empty thing.
Real Estate Investors
It’s more of a glass half full for real estate investors when mortgage rates are rising. Sure, if you’re getting a mortgage to purchase a rental home or commercial property, you’ll incur greater expense and lower cash flow. But, this negative is usually fully offset by benefits to investors.
When buyers aren’t buying, they have to live somewhere. They rent, and the rising demand for rental properties increases occupancy rates. This reduces vacancy costs, with more renters renewing leases rather than shopping again and moving when properties are scarce. There are ways that a property management company like Benefit National Property Management in Temecula, CA can help reduce occupancy turnover times.
Back to occupancy, it’s just good old “supply and demand” in action. Reduce the supply and/or increase the demand and prices rise. When occupancy rates are high, rents can usually be increased without a significant effect on vacancy costs. A Murrieta property manager can be helpful in determining what your home can be rented for in the open market.
When interest rates rise, fewer people buy and more people rent. Competition for good rental properties increases, and rents can be raised. This increases cash flow and NOI, Net Operating Income. It’s hard to find any bad news in this situation.
Commercial real estate and multi-family investors use capitalization rates to value properties. When you can raise rents without increasing expenses, your NOI increases. Since cap rate is a ratio of net operating income to the property’s value, this is a positive thing.
Annual NOI / Property Value or Sale Price = Cap Rate
Let’s do an example using a small six-unit apartment project currently valued at $330,000. The investor owner is able to raise rents by $75/month per unit and all are occupied. Prior to the increase, the rent was $700/month per unit, with NOI of $25,200 annually. Here’s how it looks.
$25,200 / $330,000 = .076 or 7.6%
Adding the $75/month/unit extra rent increases the NOI to $30,600. New calculation:
$30,600 / $330,000 = .09 or 9%
Actually, if the investor owner wanted to sell, and prevailing comparable property cap rates in the area averaged 7.6%, investor buyers would use that number to determine the current approximate value of the property they’re thinking of buying. So, forgetting the $330,000 value you placed on the property arbitrarily based on your estimate or an old appraisal, let’s see the difference:
The interested buyer would ask for your NOI, and you would give them the higher rent accurate figure of $30,600. The formula now looks like this:
NOI / Cap Rate = Property Value
$30,600 / .076 = $402,631
Whether or not you could logically expect to get that for the property, the fact is that the buyer is going to go into the negotiation with a higher estimate of value, so you’ll definitely get more than the $330,000 figure. At the very least, they would give your property some serious consideration over others. Of course, if other properties were averaging sold price cap rates of 9%, then that $330,000 is right on the mark. You simply brought your value up to where it should be with the rent increase, as before it was below comparable properties’ values based on cap rate.
So, investors, the rate increase glass is half full, or maybe more!