Real Estate Weekly
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Debt & Equity

What rising interest rates would mean for real estate investing

MikeHoweHeadShotBy Michael Howe, director,
Institutional Products,
PENSCO Trust Company

For the past six years, the arrival of a New Year has also meant the arrival of media speculation that this will be the year that the Federal Reserve will raise its namesake fed funds rate.

But in prior years, the speculation remained just that — speculation. But at its policy meeting in December, the Fed indicated that 2015 is likely to be the year that it raises interest rates, although the central bank said it will be “patient” before taking rates up from their historically low levels.

The Fed has held its benchmark lending rate at a range of 0% to 0.25% since December 2008, as it works to stimulate an ailing economy that has been slow to recover from the Great Recession.

Falling oil prices have called into question the timing of a potential rate hike, given that the decline in oil prices could lead to lower inflation – a key factor that will influence the Fed’s decision to raise rates.

But minutes released from the central bank’s December meeting show that many Fed officials expect oil’s impact on inflation to be temporary and that inflation should continue to move toward its two percent target.

Here’s a look at a number of ways that higher rates could have an impact on real estate investing going forward:

REITs: REITs pay out at least 90 percent of their taxable income to shareholders in the form of dividends and higher rates could undercut REITs by making their dividends look less compelling compared with bonds.
This could have a particular impact on highly leveraged REITs, where investors have come to expect an attractive dividend in return for the risk they are taking. But all REITs are not created equal and some will be better poised to weather a rising rate environment.
For instance, REITs that invest in self-storage facilities and multi-family complexes have more flexibility to raise rents to compensate for rising rates. REITs, as a sector, have also shown resiliency in the face of rising rates. From 2004-2006, when the Fed raised rates 17 times, U.S. publicly traded REITs recorded annual returns of nearly 28%, including dividends

Residential Investment Properties: Holding rental properties in a self-directed IRA is a popular investment strategy and Trulia has forecast strong rental demand for 2015. But any increase in mortgage rates could raise the cost of purchasing investment properties. Investors who finance the purchase of a property with a mortgage will need to consider whether the amount of rent they can charge will be adequate to cover a monthly mortgage payment, as well as ongoing maintenance and repair.
At the same time, rising rates tend to indicate an improving economy. That means investors may be able to charge higher rents, which could compensate for a higher mortgage payment. Investors could also see the value of their property increase due to overall home price appreciation if a stronger economy drives up real estate prices, especially in hot markets.

Commercial Property Investing: An uptick in lending rates usually translates into lower cash returns for investors who use leverage to buy investment properties. On the other hand, rising interest rates also suggest that the economy is improving. That, in turn, could lead to higher demand for commercial property, and potentially higher rental rates.

Inflation: Real estate has traditionally been viewed as a hedge against inflation. While rising interest rates can reduce the value of future cash flows, property values tend to rise in an inflationary environment. In addition, rents can often be raised to keep pace with an overall increase in prices.
If the value of the property increase that is driven by inflation outweighs the decrease in the property’s value due to rising rates, the results can be a net positive.

The Fed has said it does not expect to begin raising rates “for at least the next couple of meetings,” meaning any hike in rates likely wouldn’t be seen before April.

While Fed officials have said that lower oil prices should provide a boost for consumers by putting more money in their pockets, the central bank will no doubt be watching to see if dropping oil prices are hurting U.S. economic growth and will necessitate a delay in raising rates.

This gives investors plenty of time to consider how a higher rate environment might affect their overall portfolio and investment strategy.

In general, real estate can provide some much-needed diversification to existing investments and holding real estate in an IRA means investors can get the added benefit of tax-advantaged growth.

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