How could a rise in interest rates affect your real estate investments?

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More and more over the few last months, I’ve been asked how high I think interest rates are going to go, and how this might impact the Real Estate market.

It’s important to remember we live in a global market and so you need pay attention to the trends happening worldwide. Over time you start to develop a sense of where the market could be going and you can adapt your approach to investment to suit the patterns you see emerging.

Over the next 2-3 years we could see a whole generation of investors wiped out, because they’re either going miss the signals or ignore them because they don’t like what they see. A lot of the time, the information that you don’t want to hear is the exact thing you need to hear. The information that you want to hear is often the information that sends you down the wrong path and gets you into trouble.

‘When the US sneezes, the world catches a cold’

On 26th August, Federal Reserve chairman Jerome Powell gave a speech that was just 10 minutes long, but that was still long enough for Elon Musk and Jeff Bezos to see their net worth drop by about $80 billion.

How could such short speech have such a big impact? Because in it Powell destroyed the expectations of the stock market. It crashed almost instantly – he told people what they definitely did not want to hear!

For a long time now there’s been an almost irrational optimism in the stock market, but the time may have come to face up to the fact, the days when you might double your portfolio in a year or two are likely behind us.

And that’s where things get tricky. People adore an upward-only market. There’s been an assumption that because inflation had ticked down slightly, Powell and the Federal Reserve would halt the interest rate hikes, not dare to continue to truly painful levels.

In the US, they’ve gone up from almost 0% to 2.5%, which might not sound like much but when you’re paying a margin on top of that (for example, your mortgage), then suddenly its a noticeable difference. Investors believed 2.5% (or thereabouts) was where interest rate increases would stop.

Then Powell wiped that off the table, saying they would do whatever it takes to deal with inflation and get things back from the current rate of 8%, down to 2%.

So what does that mean in real terms? It’s going to mean economic pain, unemployment, the stalling of economic growth and businesses under pressure. This did not make him popular, but it did make people realise that he’s serious about inflation.

Extreme measures

So why would Powell go to such seemingly extreme measures? It’s because history recorded how the US attempted to fix inflation back in the 1970s.

Back then, the Federal Reserve tried to keep everyone happy and prevent any damage to the economy, only raising interest by a small amount. This led to fluctuating economic growth and more problems in the long run: inflation came back with a vengeance and caused far more damage.

In this case, for Powell to fight inflation, his number one priority, he’s going to have to lift interest rates to much higher, unfamiliar levels. His speech highlighted that he’s still got a long way to go.

His plan here is to fight it in one fell swoop and get inflation back to 2% – taking as long as they need to take. Naturally that spooked everyone in the market who suddenly realised they weren’t ready for this news, that their models were all based on the wrong assumption, that rates would stop rising at 2.5%.

Yes pain is coming and it’s going to be felt by a lot of investors. There will be job losses and as politically unpopular as that might be, it’s a critical step to getting inflation back under control, because once it becomes embedded in an economy, it’s very difficult to get rid of.

How will this affect my own interest rates?  

Inflation needs to come down to 2% from 8% and currently there is speculation interest rates could rise from 2.5% to 5% – personally I think that could be a tepid approach. History has shown us that if you want to get inflation down, you have to bring interest rates up to match the level of inflation. So 8% could be where it’s going, but clearly at this moment people are too scared to even consider it.

It’s unnerving for most investors, because we are facing the highest inflation in 40 years, so its very difficult to know what kind of economic models and projections to rely on. A rate of 5% in the US is going to destroy a lot of jobs and bankrupt a lot of businesses. I also believe a lot of property and real estate investors are going to be impacted by this.

So looking at the UK and Irish markets, is the same thing going to happen?

In the UK, inflation in July hit 10%, so the Bank of England is going to have to fight inflation by raising interest rates substantially. They may be slower to do this because they’re also trying to navigate Brexit, which has already done so much damage to the economy, obviously a massive hike in interest rates could create a huge recession.

For the Irish market we have to look to the larger European markets, because the interest rates are set by the European Central Bank rather than the Irish Government. Countries like German, Spain, France, the Netherlands and Italy currently have inflation rates of between 6 and 10.8%, so it’s likely the ECB will be forced to combat inflation too – this was borne out yesterday when the ECB raised its rate by 0.75% – the highest in its history.

Are there any positives?

It’s time to adjust to a new financial era after the massive growth and favourable interest rates we’ve enjoyed for the last 10 years.

There may be some pain ahead for all of us but it’s vital to remember the one thing that can set you apart as an investor: your mindset. This is absolutely critical – you’ve got to be able to control mindset, your emotions and act objectively.

I’m not telling you to hang up your boots and stop investing – that could be a big mistake. Whilst things could start to get difficult, that’s perhaps a good reason to consider getting into the market or staying in.

Take a counter intuitive approach, but steel yourself for the new reality.

Think about how you’re going to push for better terms in your deals – property prices are likely to fall back a bit. Prepare for further interest rates increases and prepare for them to remain at elevated levels for a prolonged period of time.

I got caught by rapidly changing market conditions back before 2008 and it cost me a lot of money. Interest rates started to rise and I can remember a feeling of panic, when I realised I couldn’t get attractive fixed rates any more. Had I fixed my rates earlier I could have gotten a decent rate, but by the time I decided I needed to fix them it was too late.

Many people will choose to sit on the side-lines for a couple of years and wait things out. This could also be a mistake, because when a market starts to fall, it can present a huge opportunity. As interest rates increase, affordability will become a problem. With reduced affordability, there will be less buyers, meaning there’ll be more property on the market and fewer people bidding on it.

But remember, whilst there could be good opportunities, don’t go out there thinking this will be easy. Prepare yourself for a tough time and embrace it – if you go in thinking this is going to be easy, you’re probably going to struggle. Many of the most successful companies started in times of recession, and there’s a reason for that – they figured out how to survive during difficult times and built their business around that, so when things started to improve, they were already thriving.

When you go to buy something, be discerning. Don’t build unrealistic rental projections into your model. Make conservative assumptions, assume you’ll have higher interest rates and that rents could even fall back – this could potentially happen because the affordability squeeze – people are going to have less money.

If you’re going to take anything away from this, my message would be to assume it’s going to be difficult and proceed anyway. But steel yourself for struggle – be conservative in your modelling and use pessimistic assumptions. Don’t go into any deal with rose tinted glasses and don’t get blindsided by continuity bias – assuming that markets will continue to behave as they had been.

The worst thing that can happen is it turns out to be a lot easier than you were expecting!

Since you’ve made it this far why not test your property investment readiness HERE