Why rising interest rates are good for investors

I must admit, I've been saying it for years now too: "Interest rates can't go any lower".  Well, they have and they are staying low for the time being.  But seriously, they can't go any lower than they are now, can they?  As an investor in this market, it is a win-win as long as you're in the game.  If rates stay low or do the impossible and fall lower, then your dollar gets stretched and mortgage payments go down on new purchases.  Principal gets paid down at a much faster rate, properties cash flow much easier, and people qualify to buy more things.  If rates go up, investors win too.  How can this be possible you might ask?

With rates climbing, investors that currently own property will see a lot more people needing to rent versus buy.  As rates climb, potential investors cannot qualify for the same mortgage due to the higher payment caused by the interest of the loan.  This keeps more people out of becoming landlords and instead they become renters, driving the supply of existing units down as more renters need a place now that they cannot purchase their own.  The second dynamic to this is that we are experiencing one of the few times that it makes more sense financially to buy than rent because the mortgage payment in a lot of cases is cheaper than what the asking rent is.  This causes a lot of people to take advantage of this window of opportunity to buy but when rates go up, this window closes.  Once we are back to "normal" scenarios where renting is cheaper than buying, most people will choose to rent and avoid the monthly financial stress of a higher payment and the risk of owning a property.

What investment is best for you?

As we get older, and supposedly more responsible, most wrestle with the idea of financial stability and how to finally get to a day we can retire.  The older you are the easier it is typically, since you have an established credit score and most likely have a few assets that have equity.  The younger crowd may not have life figured out as well or have as much at their disposal to go buy something new, and the two groups usually need different results with different time-frames.
A middle-aged or older individual needs something that produces more income and has less risk than the younger counterpart.  While both groups can take advantage of historically low interest rates, where to place your money or what investment to make is still a very personal decision affected by a number of outside factors.  Banks and CD's just don't pay a return that is worthwhile and the amount of time needed to realize anything substantial is longer than most are willing or able to wait.  Stocks have been doing well but there is a  fear that the market will correct itself from its all-time highs and what sectors won't be negatively affected cannot be accurately identified.  Real estate in most markets has been beaten up and stepped on to the point where there are great values for buyers able to get financing.  The old adage "Buy when others are selling, and sell when others are buying" couldn't be more accurate.
With stocks and bonds, you can leverage your money and try to determine what the future will hold but that is risky with markets at all-time highs.  Real estate allows you to leverage your money (typically 20-25% down) as well, lock in historically low interest rates so you pay down the outstanding principal much quicker, and come into the market after 6 years of it being depressed but on the upswing.  Real estate, especially income-producing property, allows your investment to make monthly returns to the owner as well as having others pay down the principal for you.  To me it is an easy decision to step into the real estate market and put my money to work for me.

Manipulating interest rates, good or evil?

The Fed keeps buying up mortgage-backed securities with the end goal of freeing up bank's money to loan to people like you and me.  This is called quantitative easing and the tactic has recently been used before (twice actually).  Coupled with that is the Fed's statement that they plan to keep short-term rates very low.  While I appreciate this and recommend anyone who can afford to borrow to do so now or in the near future, part of me wishes the Fed would allow the rates to rise slowly so there isn't a steep incline at some point.  Just like everything, there are two sides to every story but it is something to keep your eye on and will hopefully guide your short-term buying decisions with probable long-term scenarios.

Leveraging your investments

 With interest rates falling to historical lows, it brings to light the importance of financing and the benefits that securing a low rate offers.  Two major factors come in to play with these low rates: great income-to-debt ratios on the investment property and drastic principal pay-down with each principal and interest payment.  My main goal on investment properties (multi family or any income producing property) is to make sure they make money.  The second main goal for most clients is to have some write-offs to offset income.  You can't depreciate the land but you can depreciate the improvements and that cost recovery is a large aspect to many investors.  With such low interest rates, an exponentially higher portion of each payment is going towards the principal of the loan, thus causing your internal rates of return on investments to be higher.  If you can make $8000/yr on your investment due to positive cash flow, as well as reduce your principal amount owed by another $4000, that is adding 50% to your cash-on-cash returns even though it is not realized income.  This is a large aspect to investing that many people fail to acknowledge but it adds a lot of equity to your positions with these lower rates once you've held the investment for a few years.

Apartment Cap Rates Trend Lower

New market data shows that apartment cap rates are falling significantly towards values we haven't seen in 5 years.  With risk being minimized by lower interest rates, buyers are starting to purchase again due to the returns these properties are yielding.  What is starting to happen now, especially in a market like mine in Missoula, MT which is heavily dependent on the student population of the University of Montana, is that the cap rates are dropping to the point where most investors are teaming with builders to develop better class A properties instead of paying for older inventory.  At low holding costs and interest rates it makes a lot more sense to develop this income property instead of paying for a low cap rate on a sub-par property or a property that shouldn't demand the same cap rate as a new multi-family project.

Income property quick assessments

Here is a simple way to analyze an investment opportunity that you might be considering in either a multi-family property or another income producing property.  Every market is different and borrowers will all qualify for different loan structures as well, but the example set below is for a well-qualified borrower buying a four-plex (anything over this will require financing that won't be fixed on a 30 year mortgage).  The assumptions made are: 4.125% interest rate (slightly higher than current market rate due to investment loan and not a primary loan), 25% down payment, 30 year fixed mortgage, taxes of $2500/yr, insurance of $840/yr, a vacancy rate of 5% and self-managed units.  We are not including repairs, advertising, closing costs and lender fees, etc so this evaluation will look better than it actually is without those expenses accounted for.  In this example, we are dealing with a four-plex in the university area of Missoula, MT where properties rent easily due to the University of Montana and the expensive price of Missoula real estate.

*The most unrealized aspects of investing in a property like this are the cost recovery (depreciation) you capture to offset income, thus reducing tax consequences for yourself and the principal pay-down that your tenants do for you.

Example:  A four-plex is purchased for $320,000.  All units are 2-bedroom 1-bathroom units in good shape and all rent for $800/month.  Owner will pay for all sewer, water, and garbage ($100/mo) and the tenants will be responsible for their utilities, and they will be managed by the buyer.
Is this a smart investment?  As an investor in multi-family or income-properties, quick ways to evaluate this situation are to compare the cash-on-cash return and the Cap Rate this investment has.  The simple explanations to these two methods are: we want to know how much, in a percentage, each dollar invested is returning to us (cash put out returning X amount of cash from the investment) similar to what a bank expresses in their CD rates, and the Capitalization Rate (Cap Rate) is the Net Operating Income (NOI) divided by the purchase price.   Cap rates are useful to measure how an investment does after all operating expenses (utilities, advertising, vacancy, taxes, etc) are removed from the gross income taken from that property but it does not include the debt service (mortgage).  This point goes back to what I mentioned about different investors needing to put down more money or get different interest rates and finding the Cap Rate eliminates all of those discrepancies between borrowers and just tells you the amount left after all operating expenses have been paid.  From that remaining balance, the debt service and profit is left to be paid out.
In our situation, the buyer needs to put down 25% of the sold price which is $80,000 (we are not including any of the other lending fees or closing costs in this example but those will add to the total amount invested thus lowering the return).  Gross rents are $800/mo per unit *4 units*12 months =$38,400/yr (no vacancy accounted for yet).  Total utilities are $1200/year and there is no management since they will be managed by the new buyer.  The monthly mortage payment is $1163/mo on the financed portion ($320,000-$80,000)=$240,000
So here is the break-down:
                   Gross rents    $38,400
                   5% vacancy    -$1920
                   utilites             -$1200
                   Taxes             -$2500
                    Insurance         -$840
______________________________
                   NOI              $31,940
______________________________
              Debt service/yr  $-13,958                
Reducing the NOI by the debt service leaves us with the profit:  $17,982

So the Cap Rate is:    NOI/purchase price --> $31,940/$320,000 = 9.98%
The cash-on-cash return is: Profit/money invested --> $17,982/$80,000 = 22.48%
The cost recovery of this property is the value of the improvements, land not included, divided by its useful life set by our tax codes of 27.5 years.  If the building is worth $225,000 then that value divided by 27.5 = $8182 per year that you can use to offset other taxable income.  Also, every year you own this and have your tenants paying rent, you knock down your principal amount on the loan by $4135!
This example is a great investment for someone looking to own real estate in a high-rent market but it is also great for people looking to obtain passive and perpetual income.


   

Is there still a market for Montana liquor licenses?

It seems to be one of the main discussion points with commercial real estate, "Is there a liquor license included?"  I hear that question asked more than probably any other when dealing with downtown commercial properties, and rightfully so.  "Liquor License" was such a buzz word in the past decade as they skyrocketed in value and diminished in supply that everyone was intrigued by it whether they knew real estate or not.  Today, liquor licenses have slipped in value like most other goods from a high in 2009 of approximately $825,000 to $688,000 in 2010.  2011 saw that average sales price for a license rebound to $734,000 with multiple sales over $800,000.  Is there a market to sell your license?  I believe there is.