The US Federal Reserve is raising interest rates in a bid to slow down consumer demand. In Jun, they announced the biggest interest rates hike since 1994, and this is having a significant impact on the economy.
You probably are feeling it when you top up your car fuel. And as you’re looking at the losses on your growth stock portfolio.
But that’s not where it ends.
Rising rates will hurt property investors too, but there’re ways to play in a market of rising rates. That what we’ll explore in this article.
But first, let’s take a look at how rising interest rates will affect property investors.
Impact of rising rates on Property Investors
1) Lower Cashflow
If you’re covering the utilities of your rental property, especially in the case of room rentals and service accommodations, you’ll feel the direct impact as your costs increases.
2) Return on Equity drops
As the cost of borrowing rises, your return on equity will drop as well. This coupled with lower cashflows could be sufficient to kill deals.
Here’s an example, assuming:
- Purchase price of UK property: £250,000
- Loan-to-value on purchase price: 75% (~£187,500)
- Refurbishment, taxes, legal survey and other miscellaneous cost: £75,000
- Potential rental returns before taxes and miscellaneous fees: 5% annually (~£13,759)
| Interest Rate | Total Interest | ROE (p.a.) |
| 3.5% | £6,562.50 | £7,187 (8.21%) |
| 5.5% | £10,312.50 | £3,438 (3.9%) |
With rising interest rates, your returns could now be lower than investing in REITs. And that’ll be a deal breaker for many. I mean, would it still make sense for you to invest in property if the potential return is ~3.9% when you could get 5% from REITs without all the extra work?
And there’s no telling how high the interest rates will go. If it continues to go up to 7%, it could wipe out all potential returns.
3) Demand for property slows
The purpose of having higher rates is actually to push down demand so that people will hire less and borrow less.
Companies may be forced to fire and cut down their workforces. At the same time, prices will go up and people would start tightening their wallets.
Real estate demand will soften as affordability drops.
2 Types of Property Owners who will be badly hit
Now there are two types of people there is going to be badly hit.
i) Home owners
Surprise. Surprise.
Let’s give you an example in Singapore.
Assuming you have a S$3.5 million landed property in Singapore. You put in S$1M deposit and you borrowed S$2.5 million. In Singapore, loans require a principal plus interest repayment. So let’s say your repayment was actually 1.5%, but has now been bumped up to 3% because of rising rates.
How much more interest are you going to pay now?
S$37,500 per annum.
That’s just on interest alone.
What’s the real impact?
Let’s take a family with 2 to 3 children as an example.
If both are working and earning say $6,000 a month, then your disposal income is about $12,000. Assuming taxes of $2,000, then your total net income is about $10,000. On a principle plus interest repayment loan for $2.5M, that would take up about $8,000 of your total net income at 1.5% interest rate.
If the interest rate shoots up to 3%, you’ll be paying $11,125 per month on your loans.
Most families might not be able to afford it and the situation could worsen if one party loses their job. Hence, home owners in this situation would likely be forced to sell.
ii) Investors
Assuming you own a rental property in the United States or the UK, you can get as high as 5-7% net rental income. And your mortgage could be 4 – 6%. Your cash flow will likely drop as explained earlier.
You could be in a situation where your profits are thinner or maybe just breakeven.
That’s all fine and dandy. But if you’re in the more aggressive group of property investors, then you might want to watch out…
Watch your gearing ratio
If your gearing ratio is about 75%, you might still do okay. However, if you’re overleveraged at say 90% gearing, things could get a little uncomfortable. This is especially true if your cash flow starts to drop.
You should keep a pool of cash reserves to ensure that you have sufficient cash flow to tie you through.
Personally, I maintain a portfolio of stocks.
Others like to manage a pool of properties financed on different gearing ratios. For example if you have a portfolio of 14 properties, some geared at 70%, some at 80% and others are not refinanced and are kept at say 60%. You will have some reserves to manage your financials.
3 things Property Investors should know now
i) Continue buying, there will be good deals
The property market is quite different from the stock markets.
Even if it comes down, you can always buy one a year, aiming for 10 properties in 10 years. But the properties you buy must meet tighter requirements.
Personally, I use two main criteria:
- return on equity should at least be 6%
- return on invested capital must be greater than 15%
Volatility is your opportunity
Unlike stock markets that are more volatile – it can go up and down over a shorter period of time, property appreciation is actually quite smooth. It keeps going up, albeit in a slower manner than stocks.
This means that any type of dips in the property markets are great opportunities.
How do these ‘dips’ come about?
I’ve shared about the two vulnerable groups above – home owners and overly geared investors.
When the markets turn against them, they are forced to sell at a loss. Some of the properties are being let go now could be highly valuable. And that’s why volatility is an opportunity.
But you’ll need to do your own due diligence to make sure that a deal checks against all your requirements and doesn’t require you to over stretch yourself financially.
I’ll be sharing how you can calculate the above with case studies from my own experience, join me at my live webinar.
Explore overseas – property supply in UK and US remain low
Currently, property supply in the UK and the US is an issue.
Why?
Because they generally don’t have that many new builds nor do they have plans to constantly build taller buildings and skyscrapers, especially in non-city areas.
Here’s a tip for investors.
When you look for a property, you generally don’t want to see more flats or condos being built next to you because these are potential competition for your rental property. Instead, you want more shops near your property so that more people want to live in that area.
Generally, in a city, the higher, the taller, the buildings, the lower, the capital appreciation.
In the UK and the US, there’s generally more upside because supply really is a huge issue.
ii) Focus on Net Operating Income
In the face of rising rates, your financial management becomes key.
You should focus on your net operating income. Estimate your rental income with more data points for accuracy. Be prepared for less margin.
iii) Don’t overpay
You should make sure that you’re paying the market price for any property deal that comes your way.
And to do so, you’ll need to learn to estimate your rental income.
For an example, watch my tutorial starting at 28:20:
How to check if an investment property is worth your money?
Here’s an example using Manchester Three60 .
1. look at recent transaction prices.
In this case, it was:
- 1 bedroom: £415 psf
- 2 bedroom: £344 psf
- 3 bedroom: £417 psf
2. Use the ‘propertyguru’ of the country to get additional information
For the UK, its rightmove.co.uk.
Get the postal code of the property, search for listing details of the property.
3. Check cost of nearby properties
Here, you’ll want to get a general sense of the price of nearby properties, and the competition that you might be up against.
By looking through these listings, you can work out the cost in psf of properties nearby.
For example, the cost of this apartment that is within 1/4 mile of the Manchester Three60 project is only £252 psf for a 3 bedroom property. That’s about 65% premium for the Manchester Three60 project!
4. Check potential rental income
Again, using rightmove.co.uk in this example, search for rental properties using the postal code of the project you’re researching on.
Select the type of apartment that you’re looking to invest in.
Here, you’ll want to take note of two important data points:
- Listing prices of existing apartments: this should give you an idea of your rental income
- Number of apartments listed: this will give you an idea of the competition
5. Repeat the above with a wider radius
Research on the properties within a wider radius to get a better understanding of the property market nearby.
You might even find better investment properties too.
6. Get to know the area
With Google maps, it is now easy for us to get an idea of the neighbourhood even if we’re located on the other side of the globe.
You can use streetview to get a feel of the neighbourhood:
7. Who are staying in the area?
If the project is something that suits your portfolio, then you’ll want to proceed to this step.
You can use websites like streetcheck.co.uk to get an idea of the people staying in the area.
Why is this important?
Your tenants will likely be of a similar demographic.
Conclusion
Interest rates are rising and it can eat into the returns of your property portfolio. In fact, portfolios that are badly managed and overly leverage will start coming under pressure.
However, this doesn’t mean that property investing will no longer work in the current climate. Opportunities still exists and there will be good deals out there.
That said, you’ve got to be very disciplined. Stick to strict selection criteria and get in only on the good deals. Make sure that it’s cashflow positive capital gains in the right city, right location. Don’t over pay for it, estimate your income properly and don’t stop buying.
