Are you a real estate investor? Are you concerned by the prospect of an interest rate increase? Interest rates are a real concern for all investors. There are basically two schools of thought on interest rate change from where we are today:
1. We will soon get to a place where the Federal Reserve Bank must raise interest rates. Rates have been artificially low for an extended period of time and this cannot continue indefinitely.
2. The Fed will continue to support interest rates at current levels. Any increase in Fed rates will increase the U.S. deficit significantly as interest payments on retiring bonds will be replaced with new bonds at higher yields.
No matter which position you take using leverage can increase your return and limit your exposure to rising rates. The concept is to lock in a rate now that will provide you an above market return. Bear in mind this is traditional mortgage finance but the key here is the protection provided against rising rates. Increasing rates will reduce your return in the example we are about to discuss. Further, remember that many of you have considerable buying power (borrowing against your own portfolio) at advantageous rates at your disposal.
An office building is fully occupied and selling for $750,000. The Net Operating Income on this property is $48,750 annually. This provides a CAP (capitalization rate also known as the income yield is a measure of the annual rate of return for a real estate investment property.) rate of 6.5%.
If the buyer chooses to put 30% down ($225,000) the borrowed or leveraged amount is $525,000. These are not hard and fast numbers. This example is for discussion purposes only.
If we use 5% (interest only) for the interest rate on borrowed funds (most likely a conservative number, extremely high if you have portfolio assets to borrow against) your debt service is $26,250.00
When we subtract debt service($26,250.00) from the NOI, net operating income ($48,750.00) our net return after interest expense is $22,500.00 annually or 10% on our investment of $225,000.00
Similarly – If a borrower can secure interest only financing at 3% (it’s out there) the debt service is reduced to $15,750.00. This increases the net return after interest expense to $33,0000 or 14.7% on our initial investment annually.
Conversely – If interest rates increase to 6.5% and the cost of the building and the NOI remain constant the debt service increases $34,125.00. The net return in this example is $14,625.00 or 6.5% on our initial investment or exactly the same for purchasing the deal for cash. A one and a half percent increase in rates eliminates the value of leverage for this example.
In closing, there is no new magic in this discussion there is just an acknowledgement that we are at a place of historic lows for borrowing money and this could very well change. Leverage is a great way to lock in a low rate today and benefit over the life of your real estate investment. Please contact me to discuss your real estate portfolio and how we can maximize value for you!