Why Your Interest Rate Doesn’t Matter

For the last few years, everyone has been watching the Fed and holding their breath while waiting to find out if interest rates would rise.

For a while, it seemed every good piece of economic data would send the market down because people feared the Fed would start raising rates. Every bad economic indicator was taken with a sigh of relief because the low-interest rate party would continue for a bit longer.

Then it happened – the Fed raised rates….and then it happened again.

…And suddenly everyone is wondering what will happen to real estate and stocks because of it. Everyone is wondering if the party is over.

And now…rates are back down.

7 Reasons to stop worrying about the Fed raising rates

I don’t have a crystal ball and I can’t tell you what will happen, but I can say that you should stop worrying about it. Here are several reasons why:

1. You probably can’t time the market (so stop trying).

There may be a few people out there who know when the market will go up and when it’ll go down. If you could predict it, you’d probably run a hedge fund. So, stop trying.

The rest of use the concept of dollar cost averaging to help us weather the storm and make money in the process.

The same is true for real estate. If you focus on buying solid, cash flowing properties even in a strong market, then when the market turns you can just focus on buying bargains.

2. High interest rates tend to signal a strong economy

The Fed tends to drop interest rates when the economy is weak in order to spur spending. So, when interest rates start going up it means the economy is strengthening. This can hardly be considered a bad thing!

3. Bond yields and Stocks are positively related

This one goes against conventional wisdom, but it appears true. Bond yields and Stock prices are positively related.

The theories state that as bond yields rise, investors will allocate more money to bonds instead of stocks. Therefore, stocks should have an inverse relationship with bond yields.

But, the recent evidence suggests otherwise.

So rising interest rates may actually bode well for a continuation of the bull market.

Why?

4. Higher interest rates means more savings (and more investing)

The Federal Reserve lowers interest rates to deter savings and encourage spending. The increased spending (hopefully) causes the economy to heat up, increasing GDP and lowering unemployment.

When the interest rates go up, people start saving more instead of spending it. Since savings means more investments, we will see an increase in demand for investments which means higher prices.

What we don’t know is how people will allocate their portfolio. As interest rates rise, people may allocate a bit more toward lower risk investments such as bonds and away from higher risk investments such as stocks or real estate.

So, we can’t tell which particular investment vehicles will perform well and which will not, but we do know that there will be more demand for investments overall which is good for everything including stocks and real estate.

5. Cap rates and interest rates aren’t completely correlated

There is obviously a strong relationship between interest rates and capitalization rates, but the relationship is closer to a .7 than to a 1.0. This means an increase in one does not always cause an increase in the other.

Looking at this graph, you can see that at any cap rate there are a lot of interest rate combinations. For example, interest rates have varied from <2% all the way to almost 6% and produced a 6 cap. You can also look at it the opposite way – at a 5% interest rate, cap rates have varied from about 5% all the way up to 10%.

As you can see, there is not a perfect correlation between the two and we should be cautious in extrapolating too much.

So, just because interest rates are going up does not mean cap rates will go up or property values will drop.

6. Higher interest rates could price people out of homes (and into apartments)

This is a great thing for income producing housing and a bad thing for single family housing. Mortgages will get more expensive as the Fed raises interest rates, so people can afford “less home” and some will be priced out completely.

So, more people will choose to rent rather than buy. Since increasing rents will also increase NOI, then investment property values will go up.

7. Rent growth tends to match inflation

One of the key reasons the Fed increases rates is to avoid inflation. As the chart illustrates, housing is the one item that is most closely matched with overall inflation.

The point is that as interest rates go up, inflation is probably going up as well which means your rents are going up. As rents go up, your property appreciates.

One big reason to be worried about interest rates

Of course, it’s not all rainbows and unicorns. There are reasons why people should start to be cautious and worry about rising interest rates.

If you don’t adapt you won’t succeed

Though rising interest rates are not specifically a bad thing, it does mean the market and economy is changing.

So, if you keep investing the same way now as you did over the last 4 or 5 years, then you will probably be left behind. Higher interest rates mean tighter spreads and lower profits on some business activity.

So, you will have to find new ways to profit and find new ways to add value to your business, real estate ventures, or portfolio.