How low will interest rates go?
It’s a question being asked by many real estate investors. We can’t predict the future, but we do know that with current interest rates below 4%, buying and refinancing activity remains as strong as ever, according to Bankrate.
A year ago the benchmark 30-year fixed mortgage rate was 5.1%. Today, it’s less than 4%, helping refinance applications to soar by 13% during October and November of 2019.
So, with interest rates this low, what’s a real estate investor to do? In this article, we’ll answer that question and explain five ways real estate investors can profit from today’s historically low interest rates.
4 Action steps to profit from low interest rates
Low interest rates provide real estate investors with the opportunity to borrow money that’s cheap. Lending standards become more relaxed, and banks begin competing harder to win your business. Here are the 4 best ways to profit from today’s low interest rates.
Please note that most of this advice applies to residential lending. This includes single-family homes, condos, 1-4 units, including both primary residences and investment properties. Once you’re in commercial lending territory—typically 5+ units—then rates rise and the rules change.
#1 Fixed rate mortgage
Fixed rate mortgages are the most common type of home loan. While they’re currently at all-time lows, there’s always the risk rates may go up in the near future. Standard lengths of terms are 15 and 30 years. Both commercial and residential lending practices allow for long term fixed rate mortgages.
Financing a rental property with a fixed rate mortgage is perfect for the buy-and-hold real estate investor. The mortgage is fully-amortized so that the payments are the same each month.
#2 Adjustable rate mortgage
An adjustable rate mortgage (ARM) can boost cash flow over the short-term, providing extra funds for rehab or repairs, the fix-and-flip investor, or value-add investors with shorter hold time horizons.
ARMs offer a fixed interest rate over a specific time period, then adjust periodically over the life of the loan. For example, a 3/1 ARM means the interest rate is fixed for the first three years, then adjusts every year. The standard ARM lengths are 3, 5, 7, and 10 years. Some lenders also offer special products that are interest-only for a defined period of time, or even for the duration of the ARM.
Important terms to know about adjustable rate mortgages include:
- Index: what economic indicator is used to calculate the interest rate of the ARM.
- Initial cap: how much the interest rate can rise during the first adjustment period.
- Periodic cap: how much the interest rate can increase from one adjustment period to the next.
- Lifetime cap: the maximum amount the interest rate can be increased over the life of the loan.
#3 Refinance where appropriate
Sometimes it makes good business sense to refinance even if there are penalties or fees from your current mortgage. If you can lock in a lower interest rate you can calculate the savings over the period of the loan and compare that to the fees you’re paying to break the loan. For instance, if you can lock in 4% versus 5% over a 15 year term fixed mortgage for $500,000, you would about $46,000 in interest alone over the length of the mortgage.
Refinance requirements for rental property vary from lender to lender. However, most banks require:
- Loan-to-value (LTV) of 75% or less.
- Good payment history on current mortgage.
- Credit score of 660 or higher.
- Detailed financial documents including tax returns, profit and loss statement, balance sheet, tenant lease agreement and proof of rent payments received.
Don’t hesitate to ask your current lender about refinancing options. Oftentimes they’ll be willing to waive or reduce any fees to keep your business.
#4 Other people’s money OPM
Experienced real estate investors often find that other investors can be an excellent source of funds. These are other people who are finding it increasingly difficult to generate decent returns on their current investments and may be interested in real estate deals you offer.
By using other people’s money, real estate investors can create an investment pool funded by OPM, use the power of leverage to buy multiple properties, and share a portion of the monthly net cash flow stream and sales profits among all of the partners.
Bonus Tip: Put cash on the sidelines To work
People who have cash sitting on the sidelines in an investment that appears to be “safe and conservative” may want to think twice. Here’s why:
- As of October 2019, the inflation rate is 1.8% according to the Bureau of Labor Statistics.
- Online-only savings accounts pay interest of about 2% while most money market accounts offer rates of between 1% and 2% (before any monthly and annual fees), according to U.S. News & World Report.
Federal Reserve policymakers have a target inflation rate of 2%, and they’re almost there. This means that investors keeping too much money in the bank are getting meager returns at best and negative real returns at worst.
To be fair, the stock market has performed exceptionally well over the past 10 years and into 2019. However, as this recent report from MarketWatch explains, the U.S. stock market is currently riskier than many people realize.
How to stress test for rising interest rates
A stress test is a “what-if” analysis that determines what the result is of something happening in the future. For example, real estate investors may ask what happens to property performance if rising unemployment rates affect rent rates, or how a longer-than-expected vacancy rate affects cash flow.
Real estate investors should also stress test for rising interest rates to make sure they can weather the storm if interest rates go up in the future.
You can stress test your investments for rising interest rates by adding 3% to your current rate to see if your property still has positive cash flow. If it doesn’t, consider your options like selling.
Does it make sense to sell?
Selling doesn’t mean giving up on real estate. Instead, real estate investors can take advantage of today’s low interest rate environment by selling property with high equity but low cash flow.
Then, use a 1031 tax deferred exchange to acquire one or more replacement properties that are lower-cost but produce more cash flow.
This strategy also gives real estate investors the perfect opportunity to mitigate risk by diversifying their portfolio. That’s because the higher the property price is, the more potential liability it has associated with it.
Low interest rate, increased opportunity, more competition
In this article we’ve discussed some of the ways that real estate investors can profit from low interest rates:
- Fixed rate mortgage
- Adjustable rate mortgage
- Refinancing pros and cons
- Stress testing and rebalancing your rental property portfolio
However, in order to make the most from today’s low rates you need to be prepared and organized. That’s because while lower interest rates create more opportunity, it also means more competition for good deals.
In the real estate investing business, the most profitable opportunities are often found in places where novice investors don’t know where to look.
For example, affordable missing middle workforce housing and investing in opportunity zones can provide potentially greater cash flows and increased tax benefits than more traditional rental properties do.