Interest rates dramatically impact real estate investment returns. You might see headlines about how today’s higher interest rates are deterring investors from making new acquisitions and causing the housing market to stall. But this is only partly correct.
The fact is, there are strategies you can use to earn a strong return on real estate investments, even when interest rates are higher than we’re used to.
And, don’t forget, today’s “high” interest rates are still below the historical average. As of Q2 2023, interest rates for a 30-year fixed mortgage are sitting below 7%. The average interest rate over the last 30 years is 7.74%.
Today’s rates feel high to us because rates have been exceptionally low for the last 20 years, falling to sub-3% during the pandemic era of the early 2020s. But before that, rates were substantially higher. Homebuyers in the early 1980s were regularly paying well over 15%, some as high as 18%!
Suddenly 7% doesn’t feel so bad.
But even small interest rate increases can impact your real estate holdings. So, in this article, we’re looking at how interest rates affect your returns and how to invest in real estate with high interest rates to maximize your return potential.
The Basics of Interest Rates
Interest is simply the cost of borrowing money. The interest rate is the specific amount being charged on a given loan. For example, if you have a mortgage loan with a 7% interest rate, you theoretically pay 7% of the loan balance annually in interest charges.
In practice, lenders use a process called “amortization” to keep your mortgage payment amounts fairly consistent, despite the loan balance decreasing month after month. This is why the early payments on a mortgage are heavily applied to interest, with more of each mortgage payment being applied toward the principal loan balance over time.
Who Sets Interest Rates?
In the US, the Federal Reserve (the Fed) is essentially responsible for setting interest rates. The Fed sets a “federal funds rate,” which is the rate commercial banks use when borrowing or lending from other commercial banks. This serves as an interest rate benchmark on which other interest rates (like mortgage interest rates) are based.
Why Do Interest Rates Go Up and Down?
Interest rates serve as a lever the Fed can adjust to stimulate the economy or slow inflation.
In the early days of the COVID pandemic, for example, when businesses were closing left and right and economic uncertainty was excessively high, the Fed voted to lower rates. This made borrowing more affordable and provided an incentive for people to make large purchases that required financing (like homebuying). However, during periods of inflation (as we saw toward the end of the pandemic), the Fed raised rates sharply to deter people from making large purchases in an effort to slow the economy’s unsustainable growth. Quick side note: take a look at our investing options during inflation to protect your investments when inflation is high.
The Direct Impact of Interest Rates on Real Estate Investing
The higher the interest rate, the more the borrower pays in interest expense. Let’s compare a property purchase with a 5% interest rate to one with a 7% interest rate to see exactly how interest rates affect monthly mortgage payments and overall interest expense.
Scenario #1: A $400,000 mortgage with a 5% interest rate
Borrowing $400,000 on a 30-year fixed interest rate of 5% would result in a monthly mortgage payment of $2,147.28 (excluding taxes and insurance). Over the term of the loan, you would pay $373,023.14 in total interest expense. If you were investing in a rental property with a rental rate of $4,000 per month, you’d have $1,852.72 after paying the principal and interest on the loan.
Scenario #2: A $400,000 mortgage with a 7% interest rate
Borrowing $400,000 on a 30-year fixed interest rate of 7% would result in a monthly mortgage payment of $2,661.21 (excluding taxes and insurance). Over the term of the loan, you would pay $558,035.59 in total interest expense. If you were investing in a rental property with a rental rate of $4,000 per month, you’d have $1,338.79 after paying the principal and interest on the loan.
Result of Comparison
An interest rate increase from 5% to 7% increases the monthly mortgage payment by $513.93, decreasing your profitability by as much. This results in a total interest expense increase of $185,012.45.
If this is the only information you have, it’s easy to see why investors consider periods of low interest rates to be among the best times to invest in real estate and hesitate to invest when rates increase.
But we’re going to show you a few strategies you can use to boost your returns even when rates are high…
Strategies for Navigating Interest Rate Changes in Real Estate Investing
Investing in real estate with high interest rates is about limiting your total interest exposure. Here are five ways you can maximize return potential when interest rates are higher than normal.
1. Consider an Adjustable-Rate Mortgage (ARM)
Unlike fixed-rate mortgages, adjustable-rate mortgages (ARMs) automatically fluctuate with the market (typically after a set number of years). If rates come back down in the future, you won’t have to take any action to take advantage of the lower mortgage rates. But beware, if rates increase, your rate will also go up (typically with an increase cap to prevent your mortgage from suddenly becoming unaffordable in the event of a steep increase).
2. Be Ready to Refinance
Choosing a fixed-rate mortgage doesn’t necessarily mean you’re committed to that interest rate for the full term of the loan. Refinancing allows you to replace your current mortgage with a new loan, under new terms. So, if rates decrease in the future, you could refinance to the new, lower rates. Just know that there are fees associated with refinancing, so you generally want to wait for a substantial rate decrease before applying for a refinance.
3. Choose Short-Term Investments
Quick house flips can be an attractive option when interest rates are high because you can get in and out before incurring the full interest expense. Make sure your loan allows for an early payoff so that you aren’t hit with a penalty when you sell the property and repay the loan before the end of the term.
4. Be the Lender
If you’re not comfortable borrowing against a property while rates are high, why not cash in on the other side of the equation by loaning money to others? Buying real estate notes, issuing hard money loans, and investing in tax liens are all ways to invest in real estate without buying property. In each case, you’re the one loaning money, so you’re able to take advantage of higher interest rates.
5. Leverage Real Estate Syndication
Real estate syndication is when multiple investors pool their funds to invest in a real estate project together and share in the profits. By dividing the required capital among multiple investors, you can minimize the amount you need to borrow at high rates. Just as importantly, you get to leverage the resources (the experience, skill, network, and systems) of the project sponsor.
For example, through a real estate syndicate, you could purchase a share of a distressed single-family home on a lot that can be zoned for multi-family residential. The capital raised from the group of investors could cover the construction cost of demolishing the existing structure and building a new multi-family structure from the ground up. This would minimize interest rate expenses while adding substantial value to the property that was purchased cheaply. The property could then be sold for immediate proceeds or held for recurring rental income and long-term appreciation.
How Gatsby Investment Navigates Changing Interest Rates
As a real estate syndication company, Gatsby Investment regularly adapts to changing market conditions. Whether we’re dealing with a buyer’s or seller’s market, working in an overpriced real estate market, or experiencing interest rate fluctuations, we continuously tailor our investment strategies to make the most of whatever condition we find the housing market in.
This is how we have generated annual average returns of 24.22% for our investors!
When you invest with us, you get the peace of mind that comes from working with a well-established investment company with a strong track record. We know how to maximize return potential, as well as the investment mistakes to avoid. And you get to lean on our experience to boost your real estate investment portfolio.