In the past 12 months, the Federal Reserve raised interest rates by 4.5%, intending to bring down inflation, which reached 40-year highs.
Prior to that, interest rates were sitting comfortably near zero. As of the February 2023 FOMC meeting, the current rate rose between 4.5% and 4.75%. While this is a massive increase, from a historical perspective, it remains low. The average interest rate from 1971 to 2022 is 5.42%, well above today’s rate. And for anyone living through the ’80s, when rates hit 20%, 4.5% is still modest.
Since the Great Recession, beginning in 2008, interest rates have remained well below average. Cheap borrowing costs became the norm and encouraged real estate portfolio growth. Now that rates are rising to a more traditional level, here’s what you need to know about their impact on mortgage rates and real estate investments.
Why The Federal Reserve Continues to Raise Rates
The Federal Reserve controls much of the US monetary policy and makes decisions based on the congressional mandate to keep prices stable and maximize employment. When the economy grows, inflation causes the cost of goods to rise. To slow inflation and stabilize prices, the Fed raises the fed funds rate, which is the rate commercial banks charge each other for overnight loans.
On the other hand, when the economy weakens or we are in a recession, rates fall to stimulate the economy. When discussing changes to the interest rate, the Fed considers economic measures such as GDP (gross domestic product), consumer spending, inflation, and production of goods in addition to external factors like war or a pandemic.
How Higher Interest Rates Impact Mortgages
The fed funds rate is the foundation for most interest rates charged by lenders and significantly impacts the economy and the cost of money.
Short-term and variable rates rely on the Prime Rate, (the rate banks charge their best customers). If the federal funds rate goes up by 0.75%, then the prime rate also increases by that amount. It directly affects all variable rate and short-term loans such as credit cards, equity lines of credit, and vehicle, personal, and business loans.
Variable rate loans tend to set the rate as prime plus a margin. Credit cards and equity lines often adjust rates in the next billing cycle. Variable mortgages are more likely to increase annually and are not directly in synch with the fed funds rate.
Fixed-rate mortgages tend to move in the same direction of the federal funds rate, but not in tandem. Other factors like mortgage demand and competition influence rates charged by lenders.
How Rising Mortgage Rates Affect Real Estate Investments
Although there is an indirect link, higher interest rates cause mortgage costs to increase, directly impacting real estate investors.
Current owners with fixed-rate mortgages may not see borrowing expenses rise but can expect to pay more in operating costs and wages. Buyers face elevated operating and borrowing budgets. Despite higher costs, as the market slows, real estate prices tend to fall, providing new buyers with an opportunity to secure property at a lower price point. In either case, rent rates generally offset cost increases.
Regardless of economic conditions, investors can run a profitable real estate business. Challenging economic conditions require better strategies, sound due diligence, and underwriting to mitigate risks associated with higher interest rates.
If you want to learn more about syndications and how you can profit with commercial real estate investments even in a recession, watch our introductory video.