We are living in unprecedented times as we transition from a low-interest rate environment to multiple rate increases that will undoubtedly have an impact on the real estate market in the short, medium, and long term. As a furnished rental investor, rising interest rates present opportunities but also potential risks that need to be carefully factored into any decision-making process. The goal of this article is to provide a comprehensive overview of all variables that must be considered when making a purchase in this interest-rate environment.
Moving Towards a Buyers Market
The peak pandemic years resulted in an ultimate seller’s market with low inventory levels, multiple offers, and bidding wars becoming the default state. The “pandemic era” market behavior was great if you already own a roaring market and even better if you’re planning your exit. But as a furnished rental investor, it was far from an ideal scenario.
The reason simply comes down to the cap rate. The higher the price of the asset, the lower the cap rate. Unlike a stock where an increased valuation is often correlated with a growing market size, there is not a strong relationship between the price of a house and the short-term rental demand. One is based on macroeconomic real estate trends, the other is based more on travel. A higher interest rate environment should directly contribute to a housing market where price cuts become more common than bidding wars, which ultimately increases the cap rate compared to the past couple of years – especially now that travel levels have returned to normality. The downward swing in prices will improve the return on investors for furnished rental investors.
Managing Carrying Costs
Of course, the biggest downside with higher interest rates is the increasing cost of borrowing. Going from a situation where many investors were getting financing rates less than 3 percent to one where 5-6 percent or higher is becoming the norm. The best approach for an investor in this market can be summarized by:
“Find Value, Keep Financing Flexible, Retain Some Liquidity”
Finding Value is more of an art than a science, but it will be easier as more desperate sellers hit the market. There are of course some well-known strategies (e.g. look for recent price cuts, make an offer early, identify properties with easy-to-fix aesthetic deficiencies, look for property photos that may poorly represent reality, and see the property before others, etc), but that is a whole different topic. In terms of financing flexibility, in a high-interest rate environment, it is worth paying more in the short term in order to refinance in the not-too-distant future (a year or two). A 7 percent rate with the flexibility to refinance after one year is likely better than a 6 percent rate locked in for five. This is debatable, but for the short-term rental investor (in a high-interest rate environment) who is trying to generate consistent cash flow for many years, this has proven in most cases to be a better approach. That brings us to retaining some liquidity. Unlike long-term rentals, furnished rentals will have a “low season” and in some cases, a couple of months might net an investor less than even the long-term rent. If you are launching a short-term rental in the peak for the low season at a high-interest rate it’s important to retain some liquidity to be able to cover any shortfall in income.
A Booming Rental Market
One of the mitigating factors of the higher interest rates is that rental markets in metropolitan areas are showing strong numbers. This is partially due to people deciding to rent instead of buy as well as the return to city life that’s happening as things ‘go back to normal. There is, of course, a relationship between the general rental market and the furnished rental market but it is not that obvious from a birds-eye view. With respect to “vacation rentals” – typically 3-14 days – the general rental market’s impact is negligible as vacation rentals are more based on travel demand (which has also bounced back). However, once we get to longer stays (14-60 days), the impact of the general rental market is strong. For those doing vacation rentals, in the low season it’s common to aim for longer stays and so depending on the strength of the general rental market it can make the “low season” stronger (helping offset the risk of a cash shortfall during an off-season month). For those doing executive rentals of 30 days and over (due to preferences or regulatory constraints), the recent trend has a more direct impact that is keeping executive rental rates strong.
It’s an interesting time to be in real estate with so many things changing fast and the various sub-markets within the industry evolving. Like most ‘market movements’ there will always be those that understand the trends and can identify opportunities that work to their benefit. The key is to be strategic, open-minded, and disciplined. But more importantly, to have a long-term mindset with every real estate investment. While in today’s environment it’s impossible to know what will happen tomorrow, a well-thought-out decision will always pay off in the long term.