Rental Properties – How does a change in interest rates affect my ROI?
This is a question that many rental investors have been asking and the answer is complicated. Higher interest rates will likely reduce the return on investment (ROI) and cash flow of your rental property due to increased mortgage payments.
If your rental mortgage is subject to a 5-year refinancing clause, your rental ROI could be lower than when you purchased the property due to the new interest rates. Additionally, it may result in reinvestment risk, as some investors with locked lower interest rates may decide to keep their current rental, as reinvesting will likely result in higher interest rates.
As a CPA, I love looking at numbers. So, let’s look at a couple of examples using pro forma financial statements. A pro forma financial statement leverages hypothetical data or assumptions about future values to project performance over a period that hasn’t yet occurred.
Grant purchases a building worth $500,000. The building is financed with a 15-year, $400,000 loan. The building provides $45,000 in annual rental income in its pro forma. The pro forma expects a three percent increase in rental income, property taxes, and maintenance expenses each year. Depreciation is calculated over 39 years.
In Example 1, Grant purchases the building in 2022 with a fixed interest rate of 4.75%. The first ten years would look like this:
In Example 2, Grant purchases the building in 2023, with a fixed interest rate of 8.5%, the first ten year would look like this:
As demonstrated in the examples above, a significant investment opportunity hinges largely on one crucial factor – interest rates. While rising interest rates could result in increased rents (as fewer individuals may want to take out a mortgage), and rentals are typically a long-term game even though short-term ROI are diminished, long-term appreciation and rental income can still make these a worthwhile investment. Like I said, it’s complicated.