What Happens if Interest Rates Increase?

Posted by Ed McKnight on 12/11/20
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Introduction

What Happens if Interest Rates Increase?

Right now, interest rates are at a record low.

That is part of the reason more Kiwis are exploring the housing market, to live in and as an investment.

Many Kiwis who’ve owned homes for a while remember when interest rates were 20%-plus. These people are rightly concerned. What happens if interest rates go up and they can’t afford the new properties they intend to buy?

The good news is two-fold. First, interest rates are unlikely to increase back to the levels seen in the ’80s because we now have low and stable inflation.

Secondly, low interest rates have made most investment properties cashflow positive. In other words, they don’t require a ‘top-up’ or a cash flow contribution from the investor each week to cover all their costs.

That presents an opportunity. Investors can save the cash their properties produce now so that if interest rates go up later they have a buffer to cover those higher mortgage costs.

Because we, at Opes Partners, love to crunch data, we have created a model to figure out what the opportunity looks like for investors.

The model explained

The Story Behind the Model

In this model someone buys an investment property that earns a positive cashflow. They fix the interest rate for 5 years and over that period they save cash.

After 5 years, interest rates have increased. They refix the mortgage at a higher rate. Those higher mortgage costs cause property to become negatively geared, and the property makes a cash flow loss.

But, rather than topping up the property themselves, the investor now uses the cash they have saved to pay for higher interest costs.

The model aims to answer the question: how high can the interest rate go so that by the end of 10 years there are no savings left and the investor still hasn’t had to put cash in?

SetUp Of the Model

Set-Up Of the Model – The First 5 Years.

Let’s say an investor buys a property worth $500,000, which will rent for $500 a week.

They borrow all of the money to purchase this property and also borrow set-up costs of $3,500 to cover legal, valuation and accounting fees.

That sees them borrowing a total of $503,500 from the bank. Then fix this for 5 years at the current interest rate of 2.99%. In dollar terms, that’s $15,054.65 a year.

Let’s say the investor is prudent and only budgets for 49 weeks’ worth of rent per year and faces the standard operating costs we usually budget for here at Opes Partners.

That means this property would generate a cash surplus of $1,062.19 in the first year, or $20.43 a week.

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Over the next 5 years rents are likely to increase by 3% per year. At the same time, most operating costs will increase at the rate of inflation. The exceptions are property management and letting fees, which are tied directly to the rent charged.

But the most expensive cost – the mortgage – stays the same, because the interest rate is fixed. That means that over 5 years the property is forecast to become more profitable.

The first year it is forecast to make $20.43 a week, then $30.85 a week in the second year. It goes up to $41.61 in the third year, $52.71 in the fourth and $64.71 in the fifth.

The whole time all of this money has been saved in a separate bank account, earning interest of 2%.

Over those 5 years, the property is forecast to earn a total of $11,236.02.

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The question now is – “how high can interest rates go so that after 5 years that $11,236.02 has been spent topping up the property … and nothing more?”

Outcomes from the model

How High Could Interest Rates Go?

If the investor fixes again for 5 years, the interest rate could rise to 4.5% and the property would still be neutrally geared over the whole 10 years.

When interest rates initially rise, the impact on the investor is strong. Instead of making the same $3,336.99 they made in year 5, they now make a $3,668.34 loss. That’s over $7,000 difference!

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But again, over time, the cash flow is forecast to improve because rents increase faster than operating costs and the mortgage (being the most expensive cost) is locked in.

Over the next 5 years the cash flow loss on the property would improve and, eventually, the $11,236.02 would be exhausted at the end of the 10 years.

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Conclusion

The Good and Bad News

The good news from this model is that, if you are diligent and save the cash flow from your properties you can ensure that your property portfolio is stable over time.

The bad news is that we can’t predict where interest rates might go in the future. They may rise above 4.5%, or they might fall even further.

But if you’re a conservative investor, take comfort from the fact that you can invest in property now. Take advantage of low interest rates. Then, use the cash flow from your properties to protect yourself against higher rates in the future.