Rising Interest Rates And Rental Values
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Interest Rates and Rising Rental Prices
I recently bought my first home. It is a penthouse condo with a sweet rooftop deck and lots of outdoor space. I’ve lived in the city for years and never pulled the trigger on buying anything given the high prices, low square feet and outrageous property taxes. I needed a bigger place though. My 800 square foot one-bedroom apartment was not cutting it. My wife worked at home and if I wanted to transition to working at home it just couldn’t be done efficiently in a one-bed room unit. We needed at least a three bedroom place with a parking spot and still access to the city as downtown living is way better than ever moving to the suburbs.
When looking at renting a three-bedroom apartment with all of the amenities we wanted it dawned on us that buying a condo would actually be cheaper in the long-run in terms of our monthly outgoing expenses. In fact, it would be significantly cheaper, saving us $6,000-8,000 per year and also allow us to build equity in real estate. We decided to pull the trigger and put 20% down on a condo. In addition to the lower monthly outgoing expenses with homeownership versus renting, I wanted to lock in ultralow interest rates just under 4% as I don’t think I will ever be able to borrow this amount of money with a 30-year term ever again.
Things were great. We had a bigger place. Lots of outdoor space. Three bedrooms and two bathrooms. Even a heated indoor parking spot that we still haven’t filled with a car. But things in life change fast. A material life event occurred over the past few months. I’m now beginning to explore the options of renting out my condo and moving elsewhere in the world. My preliminary plans are to buy a one-way ticket to Argentina in the winter and when the spring emerges fly to Europe and live there until I get sick of being an expat. Drink Sangria under a blood red moon in the bustling cities of Spain.
Before I digress on my fantasy travel plans I wanted to go over the reasons why I would want to rent my condo out over selling the asset.
I bought in a quickly gentrifying area and property values should continue to appreciate over time. Every new development that goes up in my neighborhood increases the equity in my unit.
I only bought six months ago and I don’t want to get hit any short-term capital gains.
The transaction costs of selling real estate are quiet high and I’d rather hold the equity for the long-run than flip, pay taxes and the annoying transaction expenses.
I locked in rates under 4.0% and I don’t think I will ever be able to borrow at this rate ever again. It seems irrational to sell debt at this price.
I think inflation continues to ravage the global economy and owning a real asset that I can live in with a fixed rate forever seems like something I want to hold onto and not sell.
To speed up the process of potentially renting my condo out I reached out to a few brokers. When I asked them what they thought I could rent the unit out for I was shockingly surprised.
I was quoted $4,600 per month. My all in monthly costs (including property taxes, HOA and insurance) is $3,500 per month. These fixed costs will likely stay fixed over the course of the 30-year term (especially the mortgage portion) and realizing $1,100 per month in cash flow in only six months of ownership shows the power of real estate. But what really stood out to me from speaking to a broker is when they said rental rates are moving up fast and will likely continue to go up from here. That is something I want to explore today.
Thesis: Rising interest rates price potential homebuyers out of a market. Rising interest rates also limit the supply of new houses coming into the market. The combination, lack of new homebuyers and new supply in the market, will force rental rates to increase materially.
When interest rates increase individuals get priced out when attempting to purchase a home. For an example, if I wanted to buy a $400,000 home with a 4% rate on a 30-year term, my monthly payment would be $1,900. If rates moved up 1% to 5%, my monthly payment would rise to $2,138 or a $238 increase. The higher rates move up the more priced out individuals will be, forcing them to rent instead of owning a home.
Higher interest rates also increase the cost of capital for any investor looking to bring on new homes to the market. Just as in the prior example with the individual looking to buy a home, as interest rates rise, the cost to build new home supply increases, limiting the supply of new homes coming to the market.
Based on these two examples, rising interest rates limit the supply of new homes to the market and also limits the number of homebuyers who can afford to buy a new place. These two limitations on the housing market will then in turn increase the demand for rental units in any given market. And that is exactly what has happened nationwide.
Rental prices are up 25% year-over-year for June 2022 compared to June 2021. And it doesn’t appear to be slowing down anytime soon, given the historical national consumer price index rents in the United States.
I think this trend of higher rental prices accelerates going forward as interest rates rise, inflation increases the costs of supplies, material and labor and the cost of homeownership skyrockets. Everyone who doesn’t make $500,000 per year or more will be priced out of homeownership and effectively be forced to rent until either pricing comes down or their wages go up.
Selling a real estate asset with an ultra-low interest rate that is termed out for 30-years seems like one of the worst allocation decisions one can make in this market. Controlling a real estate asset gives you homeownership in a rising rate and inflationary environment, which effectively keeps your fixed cost of living FIXED. In addition, rising rates push up rental rates which can turn your home into a cash flowing asset if you ever wanted to travel the world and live in a different area. $1,100 per month in cash flow could likely cover all of my fixed and variable expenses in a continent like South America, which would let my other investments compound into infinity and beyond.
To end this, I would be curious to talk to anyone who has lived as an expat for an extended period of time. I’m looking to make the international living a thing over the next 6 months and would be interested in chatting with anyone who has experience making this work. Feel free to reply to this email if you want to chat on this.
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