As of this writing in mid-September 2022, interest rates have been all over the news lately. I’ve mentioned high inflation before and why getting your money into physical assets like real estate is a great strategy. But how do interest rates impact all this?
First, let’s start with how we got here. As you know, inflation in the U.S. (and the world) has been rising. As of the latest August, 2022 estimates, we’re at 8.3%. That’s a significant amount that hasn’t been seen for over 40 years!
The inflation we’re seeing is a direct consequence of various factors such as increased demand coming out the pandemic, the continuing effect of supply chain shortages, and even the war in Ukraine.
The Federal Reserve (Fed) keeps tabs on this and adjusts interest rates based on what they feel the economy needs. Chairman Jay Powell has made it clear that the Fed’s goal for inflation is 2% and they will do whatever it takes to get there. See here, for just one example. Their big lever to make this happen is interest rates.
The Fed sets what’s called the Federal Funds Rate, which is the rate that banks charge each other to borrow or lend excess reserves overnight. This rate is the foundation of all mortgages and borrowing of all types. By increasing this rate, the Fed can decrease demand for good and services because it becomes more expensive to borrow money to buy TVs, cars, and homes. Decreasing demand will consequently decrease inflation, which is a very good thing.
Jerome Powell and the Fed leadership planned to meet 8 times in 2022, and every time so far they’ve decided to increase interest rates. However, as much press this interest rate is getting lately, we are nowhere near the historical high as you can see below. And inflation still hasn’t started to decrease yet!
Given the #1 priority of the Fed is to bring inflation back down to 2%, we will likely see interest rates continue to increase.
What Do We Do About It?
Increasing interest rates do make it more expensive to buy real estate, and that certainly includes apartments. In environments like this, we sharpen our pencils and make sure we are finding the best investments for our investors given these higher rates. We look at more deals and fewer make it through. Bank financing is our top source of funds to purchase apartments, so we are in constant dialogue with the lending community about the latest options we have.
One strategy that we use (and recently implemented with the Monterrey Apts in Ft Worth, TX) is to purchase a rate cap. This essentially ‘caps’ the interest rate at a certain point. It’s almost like interest rate insurance and really helps to make sure our costs to finance don’t get too high. We’ve modeled hitting this cap and we include this in our analysis in the Monterrey Apts deal and all subsequent ones for the time being.
The good news is that interest rates are still very low (as shown in the graph above). Even as interest rates rise, apartment investments have historically outperformed stocks in high interest rate environments. And with the severe shortage of housing in our country, this looks to continue going forward.