Inflation can be a real pain when it comes to your personal finances. It can also be a major factor when it comes to your investing strategy. For passive real estate investing, understanding, and considering inflation can be a pretty important factor for protecting and growing your investment portfolio.
In this blog, we’ll look at some key things to consider when investing in real estate during periods of inflation as it can be a significant force in the market, affecting asset prices and investment returns.
Keep reading to learn a little more.
Current Debt Market Interest Rates
The first thing to consider when investing during periods of inflation is that when you see market rates for a property, you need to face that as your new reality. It’s possible for operators to go back to their bank or debt broker and work with them to find a creative way to get the interest rate down. However, in most cases, they need to accept the market rate as the rate that must be used to underwrite the deal.
Investors need to consider these higher rates and look for deals that are structured around them. If the deal doesn’t pencil in with the new interest rates, it may be best to move on to another deal that fits your investment strategy.
The Relationship Between Interest Rates and Property Valuation
Property values may not always keep up with inflation. In most cases, property values will decrease in value during periods of high inflation. It’s necessary to do your homework and understand the debt market conditions in the areas where you’re considering investing.
The relationship between interest rates and property valuation is inversely proportional, meaning that as interest rates rise, property values tend to fall. However, when considering the long term, property valuations always rise—as we discuss below.
The problem that all investors face at the beginning of higher interest rate periods is that the selling groups have yet to catch up to this trend. Those selling properties, especially commercial real estate, are still considering last year’s lower interest rates as a marker, while potential buyers are less inclined to purchase at these higher prices.
What are historical returns for real estate?
For the past 20 years, the average annual return for the S&P 500 Index has been around 10 percent. If you look at the real estate sector specifically, it has kept pace with the overall depending on how you define “market”. Even when taking into account the drastic collapse in housing prices during the 2008 financial crisis, real estate still pretty much holds its own.
If you look at historical returns, there are only brief periods where values dip momentarily before resuming their upward trend. Of course, there are no guarantees, but historically drops in value tend to be transitory; based on historical returns, real estate is likely to rebound and be worth even more in the future.
Things to look out for in investment opportunities.
When it comes to real estate, remember the deal is only as good as the numbers say it is. Just because you like the price, doesn’t mean it’s a good deal. Make sure the deal’s underwriting is based on current debt market rates, and consider amortization periods, fees, pre-payment penalties, and more. If there is some kind of appreciation four or five years down the road, that’s great. But if the deal doesn’t work in the economy that is in front of you today, it’s likely best to move on to another deal.
One of the most important things to remember when looking at investment opportunities is that patience is required. You need to look at where interest rates are today, look at the deal itself, and work on those dynamics instead of rushing into a deal.
Interest Rate and Deal Dynamics
Of course, the goal is to ensure you’re getting a good return on investment (ROI) which is why you need to look at the current interest rates and how they will affect your investment. If the interest rates are too high for your investment strategy, it may not be the best time to invest in that deal. You may not receive a good ROI, and you may not be able to afford the property in the long term.
You also need to look at the deal itself. Your strategy may be to focus on property appreciation over the next several years. But to confirm that strategy, look at the real numbers today. For example, you could assume rent is going to increase by three percent a year for the next four years, and that may be enough. But, if you are buying at a 6 Cap Rate but in order to get your desired return, Cap Rates on exit must drop to 4, it may not be the deal for you. You need to do your homework and make sure the investment is a good one for you.
It’s crucial to remember that interest rates can change at any time. Keep an eye on the markets to help provide context for any deal that you may see.
What happens when rates go back down?
If interest rates on real estate go back down in the next few years, investors could be in a great position—as long as the deal worked with the higher interest rates, to begin with. As rates drop, a refinance could yield increased cash flow and profits.
Keep in mind that interest rates are just one factor to consider when investing in real estate – you should also be aware of debt market trends, the condition of the property, and other potential risks and rewards. But if you’re watching the market and waiting for the right time to invest, remember that interest rates could continue to go up in the meantime. No one can be sure when the market is going to shift or by how much.
So, remember to always consult with a financial advisor to get personalized advice based on your specific situation and risk tolerance.
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