Higher Interest Rates Blowing the Winds of Change

You can see it driving down the streets now, the market is changing. While the housing market and the multi-family market are different, both are significantly affected by rates.

In the world of single-family housing, the market driver is the buyer’s monthly payment. If interest rates go up significantly, and they have, it puts downward pressure on the prices because the buyer pool is smaller. Even in areas like the Pacific Northwest where there has been pent up demand, we are seeing more inventory, price reductions, and fewer mortgage applications.

In the multi-family world, investors are looking for yield. Although a property price based on cap rate is not affected by increases or decreases in interest rates, most of these new property acquisitions involve some type of leverage — either institutional (banks) or private investors. The lower the interest rates, the easier it is to get a profit margin on higher prices.

For example, if early 2022 saw interest rates around 3.8% and late 2022 currently sees interest rates at 5.3%, look at what that does to the margin. For example, let us say the return on investment or cap rate, which is based on a specific price, is 4.8%. In oversimplified terms that would mean a full 1% yield on the borrowed funds alone. In late 2022, at that same price and cap rate, the yield is -.05%. Ultimately, prices come down to reflect yield.

Another key factor that is significantly affecting interest rates is that the Federal Reserve stopped buying mortgage bonds. They were the biggest buyer of mortgage bonds which was putting downward pressure on interest rates. That is over for now.

What does that mean for a landlord? It depends. I think if you plan to hold on to the property another 10 years, you are going to be in good shape no matter what. If you think you might sell within the next 5 years, there are some different strategies to consider.

On the positive side, rents in high-demand areas should remain strong and could even increase. If you rent low-income housing, another positive is that major government-paid housing is here to stay. Most of the programs have been clunky at best, but they ultimately paid.

The challenge will be raising rents on tenants after their purchasing power has already been destroyed by inflation. As the recession becomes more apparent and corporate layoffs continue, it will likely cause some choppy waters. Combine this with interest rates increasing and you have a potentially fragile marketplace.

Strategies to Consider

The point here is a thought exercise on what you can do to best grow your wealth or limit downside risk. If you can consider economic and market conditions as they are coming up, you can make the moves that are best for you. In addition to these strategies, the economic occupancy of your current properties should always be number one. If getting them in market condition and rented is a daunting task, consider strategy 3 below.

Strategy number one is hold. If you are comfortable holding your rental properties for the next 10 years or so, you will certainly have an increased equity position.

Strategy number two is a “cash-out re-finance”. This is also a hold strategy, so think 10 years again. A “cash-out re-fi” is a way to tap into your equity tax-free! That’s right, the funds you pull out are loan proceeds and not taxable! You do have to go through the loan process, which can be cumbersome, but it can be well worth it.

Strategy number three is to sell and hold the contract. With this strategy, you can often sell the property at a higher price, and it’s one of the best ways to defer (or in some cases eliminate) taxes due from depreciation recapture and capital gain. You act as the bank, so your equity is protected with the security of the property, and you receive a consistent cash flow every month with none of the liability or responsibility.

Strategy number four is to sell and do a 1031 tax deferred exchange. This is perfect for the landlord who wants to switch asset classes or areas. If you want to increase your real estate holdings and remain a primary owner, you may want to consider a 1031 tax deferred exchange to address the tax due from depreciation recapture and capital gain. The catch here is the time frames, and you need to buy more than you are selling.

Strategy number five is to list it and sell it for a cash out. I recommend this strategy for landlords who have owned their property for less than 5 years or those who have a lot of leverage. Typically, their tax burden is less. For many, this strategy will incur the most taxes. Also, this requires you to find other opportunities to put your money back to work, ideally making a monthly cash flow, which can be difficult to do.

At the end of the day, keeping an eye on your rental property strategy is always smart but could be crucial when the proverbial “weather changes.” Real estate is not a liquid asset. The industry moves slowly. That’s actually a good thing if you’re considering changing your strategy.

Studying the economic “winds of change” for investment property tax strategy is a specialty of mine, so contact my office if you would like to talk about strategies for you and your family.