As we all know, interest rates have doubled in the last year and home prices are softening in some markets. Many investors are unsure if they should keep building their portfolios or take a wait-and-see approach. Many investors are wondering if now is a good time to buy real estate…
In this article, I’ll cover the three questions I’m hearing most often from investors:
- Should I wait for interest rates to go back to 3.0%? (No)
- Should I wait for home prices to drop? (Depends on the market)
- Is there a way to help offset these higher interest rates? (Yes)
Should I Wait for Interest Rates to Go Back to 3.0%?
Pandemics or other “black swan” events are a once-in-a-lifetime event (hopefully!) and we shouldn’t count on seeing 3.0% mortgage rates again in our lifetimes. The days of near-free money are over.
If rates do come down significantly in the next few years, you can always refinance at the lower rate. But sitting on the sidelines waiting for a rate drop that might never come is not a winning strategy.
As the following graph shows, mortgage rates may have already peaked and are trending downward.
Today’s 6.3% 30-year fixed rates (see graph below) are still lower than the average historical rates we’ve seen over the last 50 years (7.76% in the previous graph). All the Fed did was move interest rates up from artificially low levels to ones approaching normal.
Bottom Line: If you want to invest in rental properties, you should plan on doing so with mortgage rates in the 6.0% range.
Should I Wait for Home Prices to Drop?
Another question I get a lot is “Should I wait for home prices to drop?” To answer this, you have to look at the supply and demand for housing in each market. There are 384 Metropolitan Statistical Areas (MSAs) in the US, and each has its own characteristics.
The graph below, borrowed from Fortune.com shows how home prices in major markets have changed since their peak earlier in 2022. As you can see, certain markets are experiencing price declines, but many are basically flat:
A close inspection of the data shows that there are basically two types of markets that are currently experiencing a pullback in prices:
- Over-priced west coast markets like San Francisco (-13.1%), San Jose (-13.1%), Seattle (-11.9%), San Diego (-9.5%), Sacramento (-8.4%), Los Angeles (-7.0%), and Portland (-6.8%). Because of the higher price points in these markets, they are more rate-sensitive than the rest of the country.
- Boomtowns like Austin (-8.6%), Denver (-7.8%), Las Vegas (-7.7%), Raleigh (-5.6%), Salt Lake City (4.9%), and Nashville (-4.5%), because home prices in those markets have increased beyond what local incomes can support.
If you’re thinking of investing in any of those markets, it might make sense to wait and see where the market bottom is.
On the other hand, Midwest prices are basically flat. A $140,000 house in Cleveland is still a $140,000 house in Cleveland. That’s the advantage of linear markets: They don’t boom in good times, and they don’t bust in bad times. These markets have little downside risk.
In the Sunbelt, we’re not seeing softening of prices either because the population growth is keeping the demand for housing strong, but we are seeing softening in terms. Some sellers are offering seller incentives, which we’ll discuss in the next section.
So, if you’re hoping for another 2008-style collapse in home prices, you’ll likely be disappointed. The problem in 2008 was a potential collapse of the entire banking system, causing credit to freeze up and leaving potential buyers with no means of financing new property purchases. Today, the banking system is much more stable, and homeowners are sitting on much more equity than in 2008.
In today’s environment, your best bet is to avoid buying in the overpriced coastal markets or the boomtowns and focus on the Midwest and Sunbelt markets that are stable and have minimal downside risk.
Is There a Way to Help Offset Higher Interest Rates?
In the “new normal” we’re operating in, many of our property teams are helping investors with seller incentives that can help offset the current interest rates.
Free Property Management
Some of our property providers are offering free property management for the first year. On a $1,400 per month rental, that could save you up to $1,500 in your first year and increase your cash flow.
Paying Down the Interest Rate
Another more common way sellers are helping investors is by “paying down” the interest rate by paying points up front. (A “point” is just a percentage of the loan amount.) We’re seeing sellers paying up to two points in exchange for a lower interest rate for the buyer.
As an example, consider the 3/2 home in Cleveland OH below. In the base case (middle column), the investor is paying the current 6.75% rate on a 7/1 Adjustable-Rate Mortgage (ARM), which still has healthy cash flow returns of 7.8%. (Rate information courtesy of Shawn Huss, of Warsaw Federal Bank, SHuss@WarsawFederal.com.)
As shown in the third column, with the seller contributing two points (2.0% x $105,000 loan amount = $2,100), the seller can buy down the investor’s mortgage rate by a full percentage point, to 5.75%. This reduces the monthly mortgage payment by $90 per month and increases annual cash flow by $1,080 per year! What started as a good deal with a 7.8% cash-on-cash return turned into a great deal with a 10.7% cash-on-cash return, with the seller incentive.
Here’s another thing to consider about points: Even if the seller is not offering to buy down your interest rate, it might still make sense for you to buy it down yourself. In the previous example, the $2,100 paid in points would pay for itself in two years, since it adds $1,080 to your cash flow each year.
Also, if you go this route, rather than pay those points out-of-pocket, you might even be able to add the $2,100 to the purchase price of the property (to $142,100 in our example) provided the property will appraise for the higher amount.
With these seller incentives, real estate investors can still find viable investment opportunities and build their portfolios.
Finally, let’s not forget about inflation. Inflation is currently at a 40-year high and the Fed is attempting to get it under control. No one knows how successful they’ll be or how long that will take. In the meantime, remember that inflation makes debt cheaper. Each year, your 5.75% mortgage is being paid off in cheaper-and-cheaper dollars.