Introduction to US interest rates: The US economy has entered a stage of quantitative tightening. This is characterized by a consistent increase in interest rates. According to the CME Group FedWatch Tool, the current interest rate is 200 – 225 basis points, and it is likely (20.8%) to remain that way when the next highly anticipated Fed meeting takes place on December 19, 2018. There is a 79.2% likelihood of interest rates rising, in the region of 225 – 250 basis points on the aforesaid date.
Extrapolating Fed interest rates for January 30, 2019, figures remain largely unchanged with a 19.4% probability of rates remaining in the 200 – 225 basis point range, 75.5% probability of rates in need 225 – 250 basis point range, and a 5.1% probability of rates rising beyond that in the 250 – 275 basis point range.
The Correlation between Interest Rates and Real Estate
On the face of it, it appears that higher interest rates may serve only to cool demand for real estate purchases. As an example, consider the ‘price’ of a $300,000 property when the interest rate is 1% and the equivalent ‘price’ of that same $300,000 property when the interest rate is 10%.
Clearly, higher interest rates serve to temper demand by making property much more expensive to potential homeowners. If this sentiment is pervasive, it adds downward pressure onto property prices, making them less desirable and driving up the rental market. There are many reasons why interest rates steadily increase or decrease over time. The recession in 2008 was brought about by rampant lending and culminated with the sub-prime mortgage crisis which precipitated the collapse of the property market and a mass sell-off in global bourses.
To remedy this crisis, widespread tightening took place in credit markets. The Obama administration enacted massive and unprecedented quantitative easing. This facilitated an era of interest-rate declines, making the cost of borrowed money cheap. This meant that banks, credit card companies, mortgage brokers and other lenders were pumping credit money into the economy to fast-track investment spending, property purchases, and to prop up a collapsing real estate market.
By the end of the quantitative easing spell towards 2013, the US economy was humming. The Fed under Janet Yellen decided to tighten the screws to prevent the US economy from overheating. This occurs when too much economic activity is taking place with cheap money and can lead to inflationary pressures. To rein in the rampant expenditure, interest rates started to rise. This serves as a disincentive to borrow as the cost of borrowed money is more expensive. Inflationary pressures (this is when general prices are rising) is typically associated with rising interest rates to protect consumers from decreased personal disposable incomes.
What About Real Estate Markets?
The real estate market is not homogenous across the US. Certain markets were impacted far more than others during the global financial crisis. For example, Florida was hit particularly hard as were many other states. Arizona’s real estate market, for instance, is characterized by 64% homeownership of at least 1 home, and the other 36% rentals. With regards to home warranty protection, Arizona’s real estate market surprisingly, some 80% of homeowners do not have home warranty protection while 20% of homeowners do.
How long are homebuyers staying in their home? It appears that 51% of homebuyers plan on staying in their home for at least a year while 49% of homeowners plan on staying for less than a year. These types of trends and patterns are due to the economic realities post-financial crisis. While home values typically tend to retain their value during inflationary periods, there are other ways to ‘stabilize’ property prices by adding value for potential buyers. Things like prepaid HOA fees, prepaid home warranties, and properly maintained systems and appliances can add value during uncertain times.
Bond Markets, Inflation Rates, Interest Rates, and Real Estate
If bond demand increases, interest rates typically rise. The Fed manipulates interest rates by buying and selling bonds, thereby increasing or decreasing the money supply. There is a clear, albeit non-linear relationship, between interest rates and real estate values. When all other factors are excluded, rising interest rates have a negative effect on future cash flow. This means that the value of the asset – in this case, real estate – decreases. There are several ways that interest rates impact real estate purchases (real estate demand). For example, the opportunity cost of investing in real estate when interest rates are high increases dramatically given that there is typically a fixed return on real estate. If money is better spent elsewhere, demand for real estate will decrease.
The complex relationship between inflation-linked effects and interest-rate effects on real estate is worth pointing out. If inflation is rising rapidly, this generally bodes well for hard assets like real estate. If the property value increases significantly, the inflation-linked higher valuation may outweigh the interest rate pressure on the asset. In this instance, the effect on real estate can be positive. Generally, it is accepted that real estate tends to hold its value well during inflationary times, even as interest rates are rising. Provided that banks play ball and are eager to facilitate lending to customers, this economic model can work.
Final Word: Real estate has one added advantage over other financial assets: it generally holds its value well during inflatimoney)!
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Free Mini-Course: Passive Income from Small Multifamily Properties
House Hacking: Low-Down Payment Financing to Live for Free
I love house hacking. In many ways, it’s the perfect way to buy your first rental property with no money down (or at least minimal money down).
Here’s how the traditional house hacking model works: You buy a small multifamily property (2-4 units), move into one of the units, and rent out the other(s).
There are several huge advantages to house hacking. First, you get to use homeowner financing, which is significantly cheaper (lower interest rates, lower closing costs) than rental property financing. Even more importantly, homeowner financing requires a far lower down payment.
Like, for example, a 3% down payment!
Another advantage to house hacking? Your neighboring tenants’ rent payments cover your mortgage. If you do it well, their rental income also covers expenses like repairs, vacancies, property management costs, etc.
In other words, you get to live for free. Hence the name house hacking! (Want more juicy details? Here’s a detailed house hacking case study of how one 20-something with no real estate investing experience lives for free in a duplex.)
One final advantage of house hacking is that it’s easier to manage rental units when you live at the property yourself. Think of it as property management training wheels.
House Hacking a Single-Family Home
Don’t like the idea of buying a multifamily property? Don’t sweat it – you can still house hack.
Is your property not very “segment-able”? You could rent out rooms to housemates. Or rent out rooms on Airbnb.
Another option? Deni Supplee (the co-founder of SparkRental) found a unique way to house hack her large, suburban home. As empty nesters, she and her husband Jerry had plenty of space and no one to fill it. They brought in a foreign exchange student, who has not only breathed new life into their home, but the exchange student placement service pays them a hefty monthly stipend. (If you want more information about the service she used, message us using the Chat button at the bottom right and we’ll connect you with them!)
House hacking is a fantastic way to finance and buy your first investment property. But it’s not the only way.
Investing in rental properties isn’t always easy to afford with a standard investment property loan. So, when some real estate investors first start out, with little cash for a down payment, how do they finance their first few properties?
By living in them for a time.
One approach is to move into a property that needs cosmetic updating, spend the next year updating it while you live there, then selling it for a profit and doing it all over again.
But who says you have to sell it? What if you kept it as a rental property?
The problem with rental property loans is that they typically require at least 20% down. And when you’re first starting out buying investment properties, a 20% down payment can seem unreachable.
But a 3% down payment, through a program like HomeReady or Home Possible? That’s a lot more doable.
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Conventional Investment Property Loans vs. Homeowner Loans
After extolling the virtues of house hacking, live-in flips, and other techniques for buying investment properties with homeowner financing, what are some of the other options available for investment property loans?
The first and most obvious option is conventional investment property financing. You simply call up your regular mortgage broker and ask them about their investment property loan programs.
Conventional investment property loans have their pros and cons. The biggest advantage? They tend to be priced reasonably.
Disadvantages include a slow, tedious underwriting process, stiff income requirements, and they report on your credit report.
“Brian why is that a problem? I’m not a deadbeat, I’m going to pay the mortgage on time!”
Here’s the thing about conventional investment property lenders, and homeowner lenders, for that matter: they’ll stop lending to you if you have more than a few mortgages on your credit report.
That means you have a ceiling of around three or four mortgages before you’re no longer eligible for conventional investment property financing. This is why people can only pull the old “Borrow an FHA or HomeReady mortgage, move in for a year, then move out and keep it as a rental” trick a few times before it stops working.
Other Options for Rental Property Loans
Luckily, nowadays there are excellent online investment property loans available, crowdfunding loans for investment properties, and more hard money lenders than ever before.
Check out our comparison chart of rental property loans and fix-and-flip loans, to view pricing and lending terms side-by-side.
We’ve found that online-only lenders do a particularly good job with rental property loans. Landlords can borrow a 30-year fixed mortgage, at rates equivalent to (or only slightly higher) than conventional investment property loans.
Real estate investors who specialize in flipping have even more good options. Check out the investment property loan comparison chart for a breakdown of several options.
Wrap-Up: Are HomeReady & Home Possible Loans Feasible as Investment Property Loans?
Yes, with some caveats.
First, investors must be prepared to move into the property for at least a year. If you’re looking for a straight investment property, you’ll need to look elsewhere (see our investment property loan comparison chart).
Second, buyers’ income must be in the “Goldilocks zone” – high enough to qualify for the loan, but below the local median.
Third, the loans will appear on borrowers’ credit reports. That means you will only be able to borrow a few times from government-backed or conventional lenders before hitting their mortgage loan ceiling.
Read: these Fannie and Freddie loans are not scalable in the long-term for real estate investors.
With all that said, HomeReady and Home Possible loans have some strong perks. One excellent advantage over FHA loans is that they don’t require mortgage insurance for the life of the loan: when the loan balance drops below 80% of the property value, borrowers can apply to have mortgage insurance removed.
Another perk? The low down payment required, between 3-5%. And Home Possible has particularly flexible requirements on where the down payment comes from.
Any investors considering an FHA loan for house hacking or a live-in flip should talk to their loan officer about HomeReady and Home Possible loans to compare the terms. Qualifying borrowers may find lower interest rates, lower down payments, or other advantageous loan terms compared to conventional and FHA loans.
Happy real estate investing!