Preparing for 2015: What Rising Rates Mean for Real Estate Investing
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 Fed funds rate. But in prior years, the speculation remained just that —speculation.
But at its latest policy meeting, 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.
At PENSCO a number of our clients have exposure to real estate through their self-directed IRAs, holding everything from direct real estate to mortgage notes to private equity vehicles that focus on real estate. Here’s a look at a number of ways higher rates can have an impact on real estate:
- REITs: REITs pay out at least 90% of their taxable income to shareholders in the form of dividends. As this article in the Wall Street Journal points out, 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. The WSJ says that some REITs are better poised to weather rising rates. 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. According to the article, from 2004-2006, when the Fed raised rates 17 times, U.S. publicly traded REITs recorded annual returns of nearly 28%, including dividends.
- Investment Properties: Many PENSCO clients hold rental properties in their self-directed IRAs and higher mortgage rates could raise the costs involved in purchasing these properties. Investors who must 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 monthly mortgage costs, 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 to tenants, especially in hot markets. 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.
- 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, as I mentioned above, 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. As this Fundrise blog explains, rising interest rates can reduce the value of future cash flows. But property values rise in an inflationary environment and rents can 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 value due to rising rates, the results can be net positive.
The Fed has said it does not expect to begin raising rates “for at least the next couple of meetings,” meaning any rate rise likely wouldn’t be seen before April. That gives investors time to consider how higher rates might affect their portfolio. In general, real estate can provide some much-needed diversification to your existing investments and holding real estate in your IRA means you get the added benefit of tax-deferred growth.
Want to learn more about investing in real estate with your IRA? Download our guide:
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.