When interest rates go up, most home owners react the same way – they take a big gulp. Conversely, when interest rates drop, these same people let out a big cheer.
Now, what about most property investors? How do they react?
You’re right, they react about the same. Maybe they take a bigger gulp or let out a bigger cheer, but the reaction is generally the same.
You see, for the property investor, the results are multiplied. That can be good news or bad news. If rates go up, then the 'pain' is multiplied, hence a bigger gulp. If rates go down, then the 'joy' is multiplied, hence a bigger cheer.
What I’d like to do today is put some numbers to this 'pain' and/or 'joy'. Take a look at how interest rates affect a property investor’s cash flow.
Property investor baseline situation
Let’s say our property investor has the following situation:
• Five rental properties
• $200,000 mortgage on each property
• Each property valued at say $350,000
• 7 per cent variable interest rate
• Interest only loan
• $350 per week rental income
This should be enough information for us to make some cash flow calculations.
First, let’s calculate the weekly interest on these loans.
$200,000 x 0.07 = $14,000/year
$14,000/year x 1 year/52 weeks = $269/week per property
$269/week x 5 properties = $1,345/week
Now, let’s look at the rental margin.
$350 – $269 = $81/week
$81/week x 5 properties = $405/week
So, our investor has $405 per week left over after paying interest to the bank.
Let’s estimate the other holding costs for each property.
• Insurance, say $1,000 per year = $19/week.
• Property management = 10 per cent of rent = $350 x .10 = $35/week
• Taxes = $1,500 per year = $29/week
• Maintenance = allow 5 per cent of rent = $350 x 0.05 = $18/week
Now tally up all extra costs
$19 + $35 + $29 +$18 = $101 per week
$101/week x 5 properties = $505/week
So, based on these estimates, our property investor is out of pocket each week to the tune of $405 – $505 = $100/week.
Now, let’s run the numbers for two new cases. First case is an interest rate rise. Second case is an interest rate drop. Let’s just assume a 0.5 per cent change either way.
Case 1: Interest rate rise
If interest rates rise by 0.5 per cent then our property investor is in for some “belt tightening.”
Weekly interest goes up to $1,442, that’s a $97 increase.
Assuming all the other numbers are the same, our property investor has just copped another $97 dollars in the negative each week. The cash flow has gone from negative $100 to negative $197.
Case 2: Interest rate drop
What if interest rates drop by 0.5 per cent? The interest rate goes down to 6.5 per cent.
Now our property investor will get some relief. The new weekly interest payment drops to $1,250 for the five properties. That’s a saving of $95 each week.
Again, assuming all the other numbers are the same, our property investor is now in a much better financial position. The shortfall each week is only $5.
Margin, Margin, Margin
Have you ever heard the famous answer to the question, "What are the three most important aspects of property investment?"
Remember the humorous answer, "location, location, location"?
Well, I’d like to follow that up with another question, "What are the three most important aspects of property investment finance?"
And, my answer is, "margin, margin, margin".
I feel the property investor should factor in a safety margin to guard against interest rate rises. This can be in the form of fixing the rate low. Or, it can be getting rents sufficiently high. Or, reducing the debt owed. Or … (your creative idea goes here!)
As you can see from the numbers in this article, interest rates have a significant impact on cash-flow. As property investors we need to make sure we can survive the ebb and flow of interest rate tidal changes.
What safeguards have you got in place to mitigate the impact of an interest rate rise?