Low Interest Rates

Low interest rates are very enticing. I want to suggest caution, because an increase in interest rates will dramatically affect the value of real property. Real estate is a “borrowed money” business. The cost and structure of financing determines the income valuation of the property. Similar to bonds, the value varies inversely to the yield (interest rate). As rates go up, the value goes down.

Suppose you buy a house for $200,000 and put down 20% ($40,000), and finance the 80% balance of $160,000 at 3.5% fixed rate over 30 years (360 payments of $718.47). The days of fully assumable residential loans are probably long gone, so your buyer will be forced to bring in new financing at a higher cost, which means a lower purchase price. Suppose rates jump to an astronomical 5.5%? The increase of just 2 percentage points will drop the serviceable debt load to $126,538. Divide by 80% to calculate $158,173, which is what the next buyer can afford to pay for the house at the same monthly payment of $718 and 20% down payment. That’s a whopping 21% price decline and your equity investment is wiped out. That’s a true real estate crash.

If rates are expected to go up, then calculate what your refinance or resale value will be in the future and work backward to determine what the property can afford to pay today.

Hedge funds are heavily investing in foreclosed houses and they are paying all cash to get a minimal 6% annual yield. After a few years and an increase in loan rates, those hedge funds will try to recover their equity by selling the houses to buyers that must obtain debt financing. Either the hedge fund must offer seller financing with long term, low interest rates or they will take a haircut (price reduction) for a buyer that must obtain higher cost institutional debt. Hedge funds that now are paying all cash for low yields may become the next wave of motivated sellers when interest rates increase.

Always consider your prospective investment according to what it costs to get in and what it costs to get out.

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