The profitability of rental properties in the US are affected by interest rates. Usually when a central bank decides to tighten monetary policy it slows down economic activities because businesses rely credit to grow. But for real estate investors a rising interest rate environment may be an opportunity to buy assets are a cheaper price.
One metric to measure the profitability of a real estate deal is to look at its capitalization rate, or cap rate for short. This is calculated by taking the annual net income generated by the property divided by the market value of the property. For example a multi-family apartment complex can collect a total rent of $100,000 per year. The property tax, maintenance/management fees, and any other related expenses to operate the rental building may cost a total of $30,000. After subtracting the cost from the revenue, the net income gained from this property is expected to be $70,000. We can get the cap rate by dividing this number by the market value of the property. So if the property is valued at $1,000,000 then the capitalization rate is 7% since $70,000/$1,000,000 = 0.07.
As we can see, the cap rate is an effective way to compare real estate investing opportunities. The higher the cap rate the better. And since the cap rate is based on the market value of a house or rental property and not the purchase price, it is constantly in flux and will change based on changing market conditions.
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When interest rates rise the price of rental properties tend to fall. This inverse correlation is because the real estate market is heavily based on borrowing and consumer borrowing in the forms of mortgages or home equity lines of credit. When the cost to borrow is cheap it’s easier to qualify for larger loan amounts which pushes up the price of real estate due to more supply of money. The opposite is true when interest rates are higher. For example, if a mortgage were to cost 19% per year in interest like a credit card, there would be a lot fewer home buyers willing to borrow money. This means if they want to buy a home they will need to choose something more affordable.
So in the event that interest rates rise, the market value of a property will fall. Assuming the net income gained from a property is constant, the cap rate of the investment will improve. Using the above example with the $1,000,000 rental property we can see that if the property value were to drop by 10% to $900,000, then the new capitalization rate will be 7.78% instead of 7.00%. So a 10% decrease in the value of a property will usually translate into a 10% increase in the cap rate. Usually rental prices do not fluctuate very much with interest rates but sometimes they can go up or down based on inflation or deflation.
Due to interest rates being so low for so long it is very difficult to find high cap rate investment properties in the U.S. But as the Federal Reserve tries to normalize rates over time, cap rates should move higher. At least the U.S. has higher cap rates in general than other countries such as Canada. In Vancouver or Toronto, two major metropolitan areas in Canada, a typical one bedroom condo in the city would typically earn a net income of $16,000 per year. However, the market value of that condo would probably be $500,000. That represents a cap rate of merely 3.2%. But interest rates in Canada are rising as well. If the rental rates of properties continue to climb over the next couple of years and prices remain stable then the expanding cap rate may be a positive sign for real estate investors looking to find attractive properties to buy. Like many other asset classes, a correction in price is actually a good thing for long term investors because it means the investment is relatively cheaper to buy.