What Happens To Investment Properties When Mortgage Rates Go From 3% to 5%?

By David Franklin
On June 19, 2013, Ben Bernanke, chairman of the US Federal Reserve (the US?s central bank), announced that it will start reducing its monthly purchases to $85 billion later this year and halt purchases around mid-year 2014, subject to what happens in the economy.

As a result of this announcement and in anticipation of this change, bond prices lost value as their interest rates increased and as a result, mortgage rates started to increase marginally in both the US and Canada. Subsequently, Ben Bernanke in July, in order to calm the markets, announced that the program would continue, however, rates cannot stay at these unprecedented low rates for many more years and will eventually have to increase.

The following is an analysis of the effect of a change in mortgage interest rates from 3% to 5% on residential investment properties. For this analysis, capitalization rates (cap rates) are being calculated as net rental income divided by purchase price. For example, if the net rental income is $10,000, at a 5% cap rate the purchase price would be ($10,000/.05) $200,000.

To determine expenses, the investor should investigate the market he is looking to invest in to learn what expenses the local investor uses. For example, if in the local market investors manage their properties themselves and you are trying to buy with a 5-8% property management fee, you may find that your purchase price is below the market price. For your own analysis, you would deduct all expenses as you determine them and that will likely give you a lower cap rate. The analysis assumes that the operating expenses are 30% of rental income. However, an investor should also be mindful of closing costs and what percentage of the property cost is charged by the real estate firm. Sometimes, understanding all the calculations may be tricky and therefore choosing a good real estate firm that can help people understand all the technicalities, could be vital. That said, investors may want to have a look at https://tracyhomesales.com and other such real estate websites in their locations that may help them in these matters.

The investor buying at a 5% cap rate with an 80% first mortgage at 3% will have a small positive cash flow of 2.28% based on the 20% down payment and 1.83% if 5% expenses and closing costs were added to the down payment. If this investor had to renew at a 5% rate or was reselling to another investor who was looking for the same returns, he would have to increase his rent by 20.39%. If he sold to an investor willing to accept a much smaller amount of positive cash flow, the cap rate to the buyer would be 5.75%, which would result in a decrease in the price of 13.04%. If you factor in 5% for expenses and closing costs on the initial purchase, a decrease of 17.39% would be felt. Closing costs can vary from property to property and understanding them is important. Sites like https://www.domaillerealestate.com can help investors understand the closing costs and make sure that they’re correct for the property they’re buying.

The investor buying today at a 5.5% cap rate and 3% mortgage would have to raise his rent by 18.89% or have a price decrease of 4.35% or 9.35% if you factored in 5% for expenses and closing costs.

If REIN investors can purchase at a 5.75% cap rate and have a positive cash flow at higher cap rates today with less than 5% mortgages, when interest rates increase, they will be in a better financial position than those that bought at lower cap rates.

As we know from REIN?s research, there are markets like Hamilton where REIN members can purchase at higher cap rates and it is shown that if the cap rate is above 5.75%, the better the investment is.

Investors might also want to consider obtaining 10 year mortgages – even though their rate is a bit higher than the five year rate, they are still being offered below 5%. The benefit of this mortgage term is that you do not have to be concerned about increases in rates for 10 years. Also, at the end of 10 years the principal reduction is about 25% of the mortgage amount. If rates are higher in 10 years, because of your principal reduction, if you refinanced with a new mortgage for the reduced principal amount with a 25-year amortization, you could afford an 8.3% interest rate and have the same payments as you were paying.

Naturally if the rates are lower then your monthly payments would be reduced, provided the new mortgage also had a 25 year amortization. 10 year residential mortgages can be repaid after five years upon payment of three months interest, so if rates decrease after five years, you can refinance at the lower rate, taking into account the cost of the three months interest.

Rental amount required 21,400 Increase 3,400 %age increase 18.89%