Your Life Simplified

Real Estate Investing Part 1: Holding Property & Interest Rates

June 16, 2022

Are you looking to invest in real estate? In this week’s episode of Your Life Simplified, Mike MacKelvie, wealth advisor, and Valerie Escobar, senior wealth advisor, talk about the things you should take into consideration before investing in real estate. The topics discussed include interest rates, return on investment and the advantages and disadvantages of investing in real estate.

Transcript

Mike MacKelvie: Investing in real estate during a rising interest rate environment. Is this a good idea? Is it a bad idea? What does history have to tell us? These are obviously all popular questions, and we’ll be covering all of these questions. We’ll also be providing you with a decision-making framework today—something a little bit more reliable than hopefully just a Zestimate.

My name is Michael MacKelvie. I’m a certified financial planner with Mariner Wealth Advisors. I’m joined today by Valerie Escobar, who’s also a certified financial planner with Mariner Wealth Advisors. This is Your Life Simplified. Valerie, interest rates are up, but are you up?

Valerie Escobar: I’m ready to go. How are you, Mike?

Mike: I’m doing good. I just worked remote for a little bit. So I’m back now. But interest rates have changed. It looks like the Fed is going to maybe increase them a little bit more as the year goes on. At least that’s what the market’s pricing into effect.

Valerie: Absolutely. Yeah. And that, of course, has all sorts of implications, not just emotionally on investors, but some real-life, tangible effects as far as mortgage rates and lending rates go, for sure.

Mike: Yeah. I mean there are implications really everywhere. And Jerome Powell, head of the Fed, my man has been at it over the past year. He kind of got dealt a difficult hand, obviously, a very difficult course he’s had to navigate here in the last few years. And again, the Federal Reserve is made up of a number of different people, a number of different organizations, but he’s been in his toolbox. He obviously had some stimulus by dropping interest rates, but now as inflation has taken off, we’re looking at raising interest rates. We’ve already done it. It’s been one of the sharpest increases in the history of our country.

It looks to be, again, as though we’re going to be raising rates for the rest of the year, likely 2.5% to 3% by year end, as far as the fed funds rate. But this is good for some things, like your savings account and bond yields, future bond yields that is, not good for bond prices right now, but bond yields eventually. It’s not so good for other things like the cost of a loan, which if you’re thinking about this, you may be saying, “Okay, what about real estate?” Most people are attaching a mortgage to a piece of real estate because they can’t afford the entire piece of real estate any other way. So how does this affect real estate?

It’s a pretty wide topic, Valerie, so we want to be clear, what exactly are we talking about today when we’re talking about real estate and interest rates rising?

Valerie: Right. So, a lot of people will have their primary residence, which is incredibly important, but there are a lot of different considerations that you want to take into account when looking at the house that you buy to live in versus a house that you might buy to make an investment, and so you’re looking more at returns. And so, I think the latter today is where we’re going to really spend a lot of our energies today. I think we’ll also try and point out some of the two differences as we’re going along and some of the things that might have in common, but yeah, definitely going to focus much more on the investment piece.

Mike: Yeah. So real estate, again, that you directly control, but investment properties. So we’ll cover in another episode, REITs, Real Estate Investment Trusts, and real estate ETFs, but today we’re going to be talking about investment properties, right? So, what are the effects of this rising interest rate environment on investing in real estate as investing properties, okay? So I got some history for us, Valerie.

Valerie: I love history. Tell me some.

Mike: Well, that’s typically where we look when we have questions a lot of times, right? We look to the past hopefully to learn from it. But the challenge is here, there’s not a lot of history of this sharp of an increase. It’s only happened a few times that we’ve seen interest rates really even jump more than one and half percent over this period of time. And the two different points here, I got a couple different points that it’s happened. Again, it’s only happened twice since 1976. The first was September 1979 to March 1982. And then again from September 1994 to February 1995. So, what happened during these periods of time when we saw interest rates go up? The Fed, again, increasing interest rates by over one and a half percent. What happened during these periods of time? Well, how did it affect real estate? Real estate appreciation decelerated rapidly from 12.9% to 1.1% in 1982 and from 3.2% to 2.6% in 1995.

So again, we still had appreciation during these periods of time. I think that’s something that’s worth noting. It didn’t exactly just send real estate in the opposite direction. I know there’s a lot of people waiting on the sidelines, hoping maybe for that to happen. The two times that this happened in the past, it didn’t necessarily send it in the opposite direction. It just slowed it. But in both of those periods of time, and this is important, and I’m curious what your thoughts are on this, Valerie, the real return was negative. So when you factored in inflation, which is typically a lot of times why we’re rising, why they’re raising interest rates is to combat inflation. The real return was actually negative during these periods of time for real estate.

Valerie: Right. And that’s going to be one of those main differences between your own primary residence versus a piece of investment. If you’re living there and the price of the value of your house goes down, assuming you’re going to stay there for the next 15, 20 years, who cares, right? You’re going to just stay there, ride it out. You’re going to be fine. If it’s a rental property or perhaps you’re trying to flip, then yeah, having a negative year could be something that’s pretty impactful for you. And really that’s one of those things to keep in mind is that there is a bit of a difference in that the real estate market has been just exploding recently. And like you said, it’d be really nice just to have things slow down a little bit. So far, we haven’t really quite gotten to the negative territory, but like you said, we just can learn so many things from history. And so knowing that that’s a potential in the future is something to really take into account.

Mike: Yeah. I think what underlies all of this is the health of the economy, right? So, we love to think of the Fed, Jerome Powell, my man, just to maybe like a switchboard, and he is pressing a button or pulling a lever, and that changes the entire course of everything. Obviously, there are a multitude of variables here. It certainly impacts things, right? So as interest rates go up, it becomes more expensive to borrow. And I’m already seeing this, just personally, I have a home that I listed, a personal just investment piece of real estate, I listed. And my realtor reached back out and said, “Hey, a lot of people were prequalified at let’s say $600,000, now they can actually only afford about $500,000.” And this is really starting to affect them, right? They were prequalified maybe two, three months ago when rates weren’t like this, now they’re going back and getting qualified again. And they’re looking at rates and they’re saying, “Okay, we can afford a lot less.” So obviously it’s going to affect things. In this case, it decelerated historically two separate times quite rapidly.

Again, what’s going to underlie all this is just the health of the economy. So again, this is one lever, but if we decelerate from last year where maybe some markets had 20-plus percent to 10% appreciation or 5% appreciation, and let’s say that’s still a positive real return, it’s still, maybe if you have a long enough time horizon, a worthwhile investment to consider. It’s just going to maybe be a different projection on your cap rate, which we’ll get to here in a little bit.

But, historic returns of real estate, again, so why even invest in real estate? Well, there was a white paper that came out from the San Francisco Federal Reserve Bank, and it was called “The Rate of Return of Everything.” And they looked at real estate as actually the greatest asset class over a long period of time. It was from the 1800s to 2015, and real estate actually had the best return out of all the different asset classes. So, you look at that and you say, “Okay, hey, why wouldn’t I just put all of my money into real estate?” Well, those returns are next to impossible to achieve just personally. That’s because when they’re looking at this, they’re saying that you’re globally diversified. And one of the challenges with real estate is diversification, right, Valerie?

Valerie: Yeah, absolutely. And that’s maybe one of the things that people are so willing to sacrifice because it is this tangible one thing that they’re so familiar with. And so all of a sudden, the diversification that maybe they knew logically was so important, all of a sudden is thrown out the window because they’re like, “Nope, I want this one thing.” And that it all will really depend on that.

Mike: Yeah. Again, you can’t really avoid that idiosyncratic risk, which we’ll talk about in a little bit of just real estate has a high unit cost. You want to invest in a property, you need to come up with a large down payment. It’s not like some fund or ETF that you can just buy at much smaller increments. So there’s that challenge. And then obviously, there’s the cost of ownership. There’s the cost of getting into the home and potentially selling the home at some point in time. So there are other variables that make that return incredibly challenging to get. And I want to be clear that we’re talking about investment real estate. Most people tend to overestimate the appreciation, which is quite easy to do here, given the last 10 years of appreciation with real estate. They underestimate how valuable cash flows are.

Real estate is an asset. As far as just appreciation, it’s not a great asset. It’s barely outpaced inflation long haul. And I’m speaking long periods of time here from 1891 to 2019, a real return of 0.3%. You wouldn’t be fired up about that if you’re getting 0.3% annually real return over a long period of time. So, cash flows are incredibly important when you’re factoring this in. But overall, again, there are some huge advantages here to real estate. The first I would say is just controlling your own destiny, right, Valerie? I mean, you can spend, obviously, time with this, much like owning a business, and control a little bit more of your own destiny by fixing up a property, putting in a little sweat labor, sweat equity, if you will.

Valerie: Yeah. And that’s always an interesting point, too, is because you go into it thinking very optimistically. I know how to paint. I know how to mud some drywall. I can do all of these things. And so one of the things to take into account is a direct investment. You are yourself completely responsible for it. And so if you have another job, for example, you maybe don’t have time, maybe you have to hire the labor, maybe labor’s hard to come by right now, for example. And so the beauty of it being this direct “control your own destiny” can also be the difficult part of it, is that you have all the control, and you’re therefore responsible for all of it as well.

Mike: Yeah. Again, we talked about overestimating. There’s a planning fallacy involved here. We tend to underestimate the amount of time that’s required to do things. I’m certainly guilty of this, whether it’s figuring out when I might get a project done or when I might get a proposal done, that’s why you really obviously have to budget maybe a few extra days for important measures, because we just tend to think that we’ll get things done faster than we actually do. There’s a planning fallacy there, right? Another advantage, we want to talk about advantages of real estate to start here, the leverage. So real estate, you can get a mortgage, which allows you obviously multiply your return, but that leverage can go both ways, right?

Valerie: Absolutely, yeah. And that’s the huge upside and why I think it’s one of the reasons it’s so important to have a primary residence, and that’s a whole other topic, again, but that can be a huge creator of wealth, right? You put $10,000 of your down payment and then the house grows to $20,000 in a year because you’re in this crazy market, so you made a 100% return. But really the house value itself, it was a $200,000 house, and so it only grew by 10% or so itself. But that’s the leverage that you have. But depending on the kind of mortgage you have, it really can work against you if you’re going to have a variable rate or let’s say that you lose your job and then all of a sudden you don’t have the money to make that mortgage payment. So there’s just a ton of risks that are involved as well when you talk about leverage.

Mike: Yeah. And I think people are actually looking at variable rates a lot more now than they probably would have a few years ago, because the variable rates are going to be lower than maybe what you might expect if you’re going to hold the home for maybe five years, a few years. You’re watching HGTV and you’re getting a little excited about flipping a home, but you know, again, there are challenges there if interest rates continue to rise, that rate would also increase. Another advantage here, again, is just the returns of real estate in the long haul. So, from periods of time of just 4, 5, 6… I mean, we really don’t even have to look back more than 12, 13 years to see this. It’s not a surefire thing that it’s going to work out for you, even in a decade, as far as crossing back over where you bought it.

I mean, my parents had a home that they bought in 2008, and it just crossed back over about two, three years ago than what they bought it for. And so, again, strong returns, but over long periods of time. When we’re talking about investing in real estate, the benefit is typically if you can hold it for a long period of time to fight that risk of it going down and then begin to obviously cash flow it while also paying less in the interest as the amortization schedule comes down, right? The further along you get, the less you pay in interest.

So that brings up some disadvantages, some obvious disadvantages we should talk about as far as investing real estate. It’s very easy, I think, for people to get excited about investing in real estate and talk about the advantages of it because a lot of people make good money in it. But some disadvantages. The first, idiosyncratic risk. You cannot avoid that when you’re buying individual properties. You buy one house that is a single house in a single market, in a single city, in a single state. It’s a single type of real estate. That’s not exactly diversified.

Valerie: No, absolutely. I mean, that’s just a risk that doesn’t go away. If you’re going to buy an individual home, like you said, it’s just that’s the nature of it.

Mike: Right. Another risk: It’s not passive if you want to be successful, at least in the beginning.

Valerie: I guess one of the ironies, I suppose, is that it’s taxed as passive income, though, which means you cannot use it to offset other types of income. And so those early years, you’re putting a lot of money into the thing, and it’s losing and losing and losing because the rents are not covering it. But too bad, you’re left holding that bag until into the future, and it’s anything but passive.

Mike: Yeah. I mean, when I think of passive, I think you can truly maybe step back, maybe evaluate it once or twice a year. With real estate, if you want to be successful, that’s going to be very challenging unless you may be higher elements of… you put in stage elements of control, which is going to cost money, which decreases your return. But again, planning fallacy here, we tend to underestimate how much time something will take. Another risk is the leverage. It can go both ways. Another risk beyond that: vacancy rate. So, in the last couple years with COVID, well, we had some people that maybe were paying rent and then what happened?

Valerie: The market went out, right? There was unemployment that we’d never heard of, seen. There’d never been a global pandemic like that. There was all sorts of programs out there that allowed for renters to not even have to pay the rent, and they couldn’t be evicted. And so that’s in the worst of times. Even in good times, we can see that the vacancies can just be up just because maybe you don’t have the most desirable part of town anymore. Maybe the next-door neighbor really did a nice job with their house and that one’s just the more favorable one.

Mike: Yeah. I mean I guess… and I maybe combined vacancy rate with just the risk of people paying rent in general. But again, one of the things I used to always hear, because I would teach these real estate investment courses to just real estate developers and commercial agents, is, “Well, if the market goes down, more people are going to rent.” It’s like, yes, but do you think more people might struggle to afford their rent that are already in your property? Likely. Another risk here: cost of ownership. Again, it costs money to maintain the property, which is part of what makes those returns that we see with real estate next to impossible to achieve, is there is a real cost of ownership, both with your own personal time and money. And then, liquidity. So the access to the equity in the property, Valerie.

Valerie: Right, yeah. And that’s a huge piece that I think people just forget is that you have the leverage, which means it’s working for you, that you’re able to spend somebody else’s money for this thing. But also, when there is a huge emergency, usually that’s in a time when the economy’s bad, you’ve lost your job, you can’t find tenants. Guess what? It’s also really hard to refinance the house or to sell it or to get that money. So, liquidity risk, it’s huge. And it’s something that is really hard to overcome, because when you need cash, you just need it then.

Mike: Right. And again, this is just all underscoring why real estate can be a powerful investment. But leaning into it, as a lot of people do, is maybe the sole breadwinner of your entire portfolio or your entire, let’s just say, net worth, you’re just subjecting yourself to more risk. Yeah, there’s more upside. Anytime you concentrate, there’s more upside because you’re taking on more risk. But again, these benefits, they also come with some disadvantages that are worth talking about.

So, in conclusion, we wanted to talk a little bit about just a decision-making framework to give you an idea of, “Hey, if I’m thinking about investing in a piece of real estate, how can I go about this in just an intelligent, smart way and not just feel like I’m popping up on Zillow and feeling, the feels, the intuition, hey, I think this feels right?” More of a defined decision-making process for this. And I know you had mentioned wanting to talk about cap rate.

Valerie: Absolutely, yeah. And this is a nice way because like you mentioned, especially I think programs like Zillow have really captured the emotion and excitement that goes along with finding that right property. A cap rate is a formula that will help investors be able to decide, okay, is this property valued where I need it to be? So what you do is you take the amount of rent that you could get for the whole year and then you divide that by the price of the property. There’s a whole lot of different ways investors look at that cap rate in different manners, but to make it apples for apples, if you’re a cash investor, you’re going to not have a mortgage at all versus someone that doesn’t have that.

And so, you’re going to basically value that property the same, regardless of whether or not somebody can come to the table with cash or need a mortgage. With cap rates, it’s been really interesting because in the past, so for example, we have a few rental properties ourselves and we haven’t raised rent for a long time. When you get a good renter, that’s another risk probably that you got a good renter, right? You don’t want to raise the rent because you don’t want them to go away.

Mike: You like them, too.

Valerie: They’re good people. That’s exactly where it’s been. And so, for a long time, the rent was the same and the value of the house is the same. Well, all of a sudden, the price that we’re able to get is really high, but the rent stayed low. And so that means that the cap rate, the actual return on your investment, has gone down. So, depending on your level of risk and your market, all sorts of different things, that cap rate can be anywhere between 4% is the lowest I’ve ever seen anybody be willing to tolerate to in the past. I’ve seen 12%, 13%.

And I think one piece, too, that’s really important is that the cap rate that you should want and expect needs to take into account the actual property, right? If you’ve got an older property that’s going to require a lot of maintenance and fix ups and all sorts of things as you’re going along, you’re going to need a higher cap rate because that return, you’ve got a 13% return for a cap rate, all of a sudden it’s going to really be chiseled down quite a bit by all of the ongoing expenses that go into it.

Mike: Right. The fixing up of it. Again, so generally speaking, you want it to be as high as possible, right?

Valerie: Yep, absolutely.

Mike: Yeah. And one of my good friends is actually in commercial. He works for a billionaire who invests in real estate, that’s his entire business, right. So he’ll go out, he’s looking at all these different exchanges with boots and just speaking to him about current cap rates, he said, “Hey, before we’d see about five out every 10 deals kind of made sense. Right now, it’s about one out of 50.” And part of that is the market adjusting currently to this sharp increase that we saw in interest rates. Again, I mentioned this has only happened a few times in the history of the market. So the market’s sorting this out. I think there’s a likelihood, again, it’s impossible for things not to slow with that sharp of an increase. The question is, again, how much will they slow and what will really be the impacts of this moving forward?

I think the way that you combat that, again, in the best way is just by holding it for a long period of time. So I think as far as just really a decision-making framework, yeah, looking at it objectively and thinking of it much more in terms of numbers, like a cap rate would be a great starting point. And then from there, hey, what alternatives do you have? And we can get very just narrow in our thinking here and think in isolated silos, what alternatives do you have? That’s always something to really consider, something that we definitely help people out with because it’s difficult to know when you’re not doing this all of the time.

And a lot of times, buying real estate, it does make sense, but sometimes, as I mentioned, it does not. So whether it’s maybe a home that you really want to make an investment property or a home that’s going to be a vacation home for you one, two, three weeks a year, hopefully under two weeks, if you want to keep the tax benefits of it, mapping this out is incredibly important. Again, something that we definitely help a lot of people with because once you start getting into all the different variables, it gets difficult to project.

Valerie: Absolutely, yeah. And having that extra set of ears to make sure that the emotions are in check and then, is this really right for your financial situation? As you said, you have a billionaire friend that is doing this investment.

Mike: Name drop without the name.

Valerie: But it’s easier to make money when you’ve got a lot of money and with stuff like this, there is a lot of risk. I mean, I’m sure that this person has tons of money on the side that when things go wrong, they can fix it. Whereas most of us don’t have just endless amounts of cash. And so, this can be something that can be risky, and we as advisors, that’s a big part of our job is helping make sure it’s appropriate.

Mike: Yeah. So again, in conclusion here, in summary, much of what makes real estate a powerful investment unfortunately is also it’s disadvantage, right? So it’s attractive, it’s fun, it’s exciting, but obviously that can sway you to maybe getting into a property you don’t necessarily want. The leverage of it is great or it can also hurt you. It’s interesting how many, again, of the benefits that we find here can also be potential disadvantages. So, you really want to think through this thoroughly. And again, I can’t emphasize it as objectively, as much as you can, removing that emotion from it.

So if you’re listening to this on Apple or Spotify, make sure to hit that Subscribe button. Maybe you’re on YouTube, hit that Subscribe button to listen to more content from industry professionals here at Mariner Wealth Advisors.

Again, I’m Michael MacKelvie, joined today by Valerie Escobar. You guys take care.

Valerie: Thank you so much for being with us.

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