The Impact of Interest Rates on Real Estate Investments

The Impact of Interest Rates on Real Estate Investments

Perhaps you’ve heard that the US benchmark interest rate was recently reduced by a quarter of a percent. So, is it a big deal? What does it mean for those of us who invest in Chicago real estate? Let’s discuss interest rates: how they affect your investments, what the current environment is, and how you can take advantage of the recent rate cut.

How Interest Rates Affect Your Real Estate Investments

Interest rates can have a profound impact on real estate investors. This is especially true when it comes to the interest rates on Treasury bills and interbank exchanges. In general, interest rates affect your real estate investments in a few different ways:

Interest Rates Affect the Cost of Capital

Interest rates will increase or decrease the cost of mortgage capital, which affects you every time you decide to purchase a property. Mortgage debt is more expensive when interest rates go up. Conversely, you’ll pay less when interest rates go down.

As interest rates go up, capitalization rates (also called cap rates) increase. If you aren’t familiar with this term, a cap rate is the rate of return that’s expected to be generated on a real estate investment. A cap rate is usually higher than the 10-year Treasury yield. This spread is called the risk premium. It measures the demand for an asset that has more risk than a treasury bond.

The historical risk premium on multifamily property is 260 basis points higher than the 10-year Treasury yield. Assuming net income is held steady, as interest rates go up, cap rates go up, and therefore values decrease.

And, Interest Rates Are Connected to Inflation

Oftentimes, interest rates are linked to inflation. Interest rates typically rise when an economy is doing well and the government is putting the brakes on inflation. The interest rate is based on the federal funds rate that is determined by the Federal Reserve, while inflation is the rate at which prices rise.

Usually, when interest rates are lowered, more people can borrow money—and when that happens, more people have money to spend. This can allow the economy to grow because interest rates on a savings account are low, so investors take money out of savings and put it to work in the markets. Inflation can lead to higher prices for hard assets like real estate.

Are you currently investing in multifamily properties, or are you considering doing so in the future? It’s worth considering. Multifamily properties are better-positioned in a rising interest rate environment because you can annually increase the relatively short-term lease during inflationary periods.

What’s the Current Environment of Interest Rates?

Several times each year, the U.S. Federal Reserve has a committee meeting to review financial and economic conditions and decide on monetary policy. One thing the committee does is establish interest rate targets in an effort to keep the economy balanced. They will raise or decrease interest rates to maintain stable prices, stable economic growth, and other favorable conditions.

Recently, the Federal Reserve reduced the interest rate for the first time in several years. This decision was announced on July 31st, 2019. Basically, the Fed decided to reduce the benchmark interest rate by .25%, or 25 basis points.

This is somewhat surprising due to the 10-year economic growth cycle. It is the first time since the 2008 financial crisis that the Fed has reduced the benchmark interest rate. However, it wasn’t totally unprecedented, as the Fed hinted strongly that it would most likely be reducing interest rates at its July meeting. The committee described its decision briefly in the post-meeting statement:

“In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate.”

In other words, the Fed cut the federal funds interest rate in an effort to keep the U.S. economy going strong in the near future. They don’t want a repeat of the 2008 recession, when many Americans lost their jobs.

So, Are We Going into a Recession?

Based on the decisions in the July 31st meeting—as well as the buzz among investors throughout the country—we wouldn’t blame you if you think we’re heading into a recession. So, let’s look at the facts of that.

When discussing current interest rates, it’s worth noting that we have experienced a recent slight inversion in the yield curve. This means long-term rates are lower than short-term rates, which is a sign that investors are betting on long term rates to continue to decline. Investors often expect a yield curve inversion to be an early signal to a recession.

However, this doesn’t mean that we will actually experience a recession anytime soon. The spread on this particular yield curve was very narrow and temporary, so if it’s a sign of an imminent recession, it is a weak one. And, as we already mentioned, the Fed cut interest rates in an effort to stave off recession—so if it works, we won’t have much to worry about.

In Summary…

Here’s what you should take away from this whole discussion as a real estate investor:

In general, interest rates can have a major impact on income property values. Usually, multifamily properties are better-positioned than commercial properties to take advantage of good interest rates. This is due to the shorter lease terms. Make sure to include multifamily properties in your portfolio.

The recent federal funds rate cut won’t affect most consumers directly or immediately. However, as a real estate investor, you’re in a different position. The rate cut—as small as it is—could certainly have an impact on your real estate investing business.

At this moment, we aren’t expecting to see inflation due to the inverted yield curve. To know for sure, we’ll just have to wait it out. The economy seems to be fairly well balanced at the moment and the rate cut could help in that regard.

It’s true that we have had a long cycle of economic growth and a recession will happen in the future. But even if a recession does occur in the next few years, it won’t hit every market with the same force. Luckily for those of us in the Chicago area, our local area is doing great by outpacing the country in job growth!  

Finally, we think it’s a good idea for investors to keep an eye on federal interest rate decisions, so if you aren’t already doing that, now is the time to start. We would encourage you to keep an eye on the Federal Reserve’s future decisions regarding interest rates, and of course, keep watching for signs of a future recession so that you’re prepared if the economy begins to weaken.

Chicago Real Estate Investment Solutions

Root Realty is a trusted investment advisor to countless real estate investors in the Chicago area. We partner closely with our clients to understand their goals and to offer tailored investment opportunities and property management solutions. We constantly analyze the Chicago market to uncover the best strategies for your needs, and we’re always sourcing new opportunities for you to invest in.

We’d be happy to learn about your goals and work with you to find an investment that meets your needs. At Root Realty, we make it easy to invest in real estate!