Inflation can be a significant force in the market, affecting asset prices and investment returns. It’s vital for real estate investors to understand and consider inflation when making investment decisions.
Current Debt Market Interest Rates
It isn’t in our interest for inflation to be too high. So when it is, we should expect the Federal Reserve to raise interest rates to reign it in.
The first thing to consider when investing during periods of inflation is that when you see market rates for a property’s debt, you need to face that as your new reality, even if it’s higher than you’re used to. It’s possible for operators to go back to their debt broker and work with them to find a creative way to get the interest rate down. However, in most cases, they need to accept the market rate as the rate that must be used to underwrite the deal.
Investors need to consider these higher rates and look for deals that are structured around them. If the deal doesn’t pencil in with the new interest rates, it may be best to move on to another deal that fits your investment strategy.
The Relationship Between Interest Rates and Property Valuation
Another thing that all investors should consider is that property values may not always keep up with inflation because of rising interest rates. It’s necessary to do your homework and understand the debt market conditions in the areas where you’re considering investing.
The relationship between interest rates and property valuation is inversely proportional, meaning that as interest rates rise, property value tends to fall. However, when considering the long term, property valuations always rise—as we discuss below.
The problem that all investors face at the beginning of higher interest rate periods is that the selling groups have yet to catch up to this trend. And those who just bought a property and haven’t yet stabilized it yet when rate increases start have to deal with the higher interest rates then, not when it’s convenient for them. Those selling properties, especially commercial real estate, are still considering last year’s lower interest rates as a marker, while potential buyers are less inclined to purchase at these higher prices.
What are Historical Returns for Real Estate?
For the past 20 years, the average annual return for the S&P 500 Index has been around 10 percent. If you look at the real estate sector specifically, it has done just as well as the overall market. Even when taking into account the drastic collapse in housing prices during the 2008 financial crisis, real estate still holds its own.
Real estate valuations never truly go down…at least not for long. If you look at historical returns, there are only brief periods where values dip momentarily before resuming their usual upward trend. So don’t expect a dramatic drop in value anytime soon. Based on historical returns, real estate is likely to rebound and be worth even more in the future. That’s a big part of what makes it such a great investment.
Things to Look Out for in Investment Opportunities
When it comes to real estate, it’s important to remember that the deal is only as good as the numbers say it is. Just because a property is a certain price doesn’t mean it’s a good deal. You need to make sure that the underwriting for the deal is based on where the rates are currently in the debt market, among other things. If there is some kind of appreciation four or five years down the road, that’s great. But if the deal doesn’t work in the economy that is in front of you today, it’s likely best to move on to another deal.
One of the most important things to remember when looking at investment opportunities is that patience is required. You need to look at where interest rates are today, look at the deal itself, and work on those dynamics instead of rushing into a deal.
Interest Rate and Deal Dynamics
When it comes to buying property, you want to make sure that you’re getting a good return on investment (ROI). That’s why you need to look at the current interest rates and how they will affect your investment. If the interest rates are too high for your investment strategy, it may not be the best time to invest in that deal. You may not receive a good ROI, and you may not be able to afford the property in the long term.
You also need to look at the deal itself. It’s better not to gamble that a property is going to appreciate over the next several years. Instead, look at the real numbers today. For example, if you can anticipate that rent is going to increase by three percent a year for a multifamily property, that’s all the growth you can anticipate. And if interest rates are still rising, you can expect them to drive cap rates up also, driving prices downward—so the value may stay the same or even decrease, despite the rent growth. You need to do your homework and make sure the investment is a good one for you.
It’s crucial to remember that interest rates can change at any time. Keep an eye on the markets to help provide context to any deal that you may see.
What Happens When Rates Go Back Down?
When interest rates on real estate go back down in the next few years, investors could be in a great position—as long as the deal worked with the higher interest rates to begin with. As rates drop, a refinance could yield increased cash flow and profits.
Keep in mind that interest rates are just one factor to consider when investing in real estate—you should also be aware of debt market trends, the condition of the property, and other potential risks and rewards. But if you’re watching the market and waiting for the right time to invest, remember that interest rates could continue to go up in the meantime. No one can be sure when the market is going to shift or by how much.
Further reading: Multifamily Real Estate Investments’ Performance During a Recession