Real Estate with High Interest Rates
2023 has witnessed the largest increase in interest rates in decades, casting a shadow of uncertainty over various investment avenues, particularly real estate.
This blog post delves into the dynamics of investing in real estate in such an environment, offering insights and strategies for investors to navigate these choppy waters.
Interest Rate Basics
Most investors purchase rental properties with a mortgage - mortgage interest is one of the largest expenses associated with owning a rental property. In 2023, mortgage rates have increased from ~3% to ~8%.
Let’s be detail-driven and use specific data here. A typical single-family house of $500,000 with a 25% downpayment in a strong growth market may rent for $3,200 per month.
| 3.5% Interest | 8.5% Interest | ||
|---|---|---|---|
| Total Income1 | $32,640 | $32,640 | |
| Operating Expense2 | -$12,000 | -$12,000 | |
| Mortgage | -$20,208 | -$37,317 | |
| Net Cash Flow | $432 | -$16,677 | |
The previously cash-flow neutral property is costing the owner $17k more in cash flow. Many investors rightfully question: why bother investing in rental real estate at all? Why not just put all cash into high-yield savings accounts or treasury and earn 5% interest with no risk?
Real Estate vs Other Assets
To answer this asset allocation question, it’s important to compare the common asset classes, apples-to-apples, without any mortgages or debt:
| (As of Q3 2023) | Real Estate | S&P 500 | Cash/Treasury | |
|---|---|---|---|---|
| Yield (Rent/Dividend/Interest) | 4.5% | 1.6%3 | 5.0% | |
| Appreciation (Conservative) | 2.0%4 | 4.6%5 | - | |
| Appreciation (Historical) | 4.4%6 | 7.8%7 | - | |
| Total Return (Conservative) | 6.5% | 6.2% | 5.0% | |
| Total Return (Historical) | 8.9% | 9.4% | ~3.0% | |
| Tax Rate (Top Bracket) | Deferred | 23.8% | 37.0% | |
If real estate is compared “fairly” with other assets, without debt, it carries a reasonably positive rental yield. In our example, the net rental yield (including all operating costs), is roughly similar to purchasing treasury bills at 5%. Historically, real estate also has appreciated over decades. Even if we assume a more conservative, 2% appreciation4 going forward, the total return is still higher than cash. Stocks face a similar profile: S&P 500, the standard index benchmark for US stock portfolio, has a much lower dividend yield compared to treasury, but the long-term appreciation more than made up for it.
The extra return for both stock and real estate comes at a cost of volatility: in any given year, they may outperform or underperform. However, this trade-off is perfect for an investor with a long time horizon. They are also more tax efficient than treasury for most high-income investors due to lower capital gains tax rates and tax advantage associated with real estate ownership.
Mortgage is an option, not a requirement
Today’s “high interest environment” is not unheard of from a historical perspective: interest rates reached ~20% in the 1980s! Most financial advice recommends a sizable allocation toward stocks due to their long-run appreciation, regardless of macroeconomic conditions, because a consistent plan over the long run is key to investment success.
Real estate has a similar return profile as well, just with a bit higher rental yield and a bit lower historical appreciation. An investor should approach real estate investment with a similar mental framework. In the past decade (2012 - 2022), the US suffered a large crash in real estate prices in 2008-2010 and also happened to have very low interest rates. As a consequence, many rental real estate were “cash flow positive” even when purchased with high debt. This benefited a lot of real estate investors. Implicitly, the past decade “miscalibrated” our mental model of investing: many investors now assume that real estate is not worth investing if it’s not “cash flow positive”.
The past decade has been the exception, not the norm. In reality, real estate today is still producing relatively high yield when purchased on an all-cash basis and should be considered for a sizable portion of one’s portfolio. An all-cash investor may even be able to purchase most real estate at a slight discount because most sellers prefer taking all-cash offers for their simplicity and certainty.
A smart real estate investor should use a mortgage as an option: if rates drop in the future, she may refinance or leverage her income to purchase more real estate. In a high-rate environment, she should consider an all-cash purchase or a higher downpayment amount. Either way, she should consider consistent allocation into real estate, as part of a balanced, diversified portfolio across different assets.
- 1.Assumes 5% vacancy and 10% property management ↩
- 2.Assumes $5,000 repairs, $5,000 property taxes, and $2,000 insurance. ↩
- 3.S&P 500 has an average dividend yield of 1.6% as of this writing. ↩
- 4.Federal Reserve’s official inflation target is 2% over the long term. ↩
- 5.S&P has an average Price to Earning Ratio (P/E) of around 24, so a “typical $100 stock” represent roughly $4.2 of earnings per share per year, in which $1.6 is paid to the investor as dividend and $2.6 is reinvested into the company. Assuming a 2% inflationary appreciation on top of the $2.6, we may use a conservative 4.6% estimate of appreciation going forward. ↩
- 6.Case-Shiller U.S. National Home Price Index, St Louis Federal Reserve ↩
- 7.Based on 1987-2023, same period for longest Case-Shiller data. ↩