The latest federal interest rate hike (the sixth in 2022) is starting to hurt everyone who borrows money or owes money in non-fixed debt.
With inflation the worst in decades and recession indicators red, we’ll go over some of the reasons why many real estate investors are going to be in trouble in this next cycle.
1.Rising Interest Rates and Debt
We all know the formula of real estate investing: income – (minus) expenses – (minus) debt = cash flow.
Unfortunately, many real estate investments are failing because the investors purchased deals that didn’t work with the intention of rehabbing them and selling them for more money than they bought them for. They never accounted for rising debt costs or a changing market. Now they are stuck managing a property that just doesn’t have cash flow. They basically wanted to “flip” the property and weren’t trying to invest for the long term.
According to the Fed’s own internal projections, interest rates are projected to near 5% in 2023. The 30-year mortgage rate has also soared to 7.2%, a far cry from the 3.9% average seen in 2019.
This is starting to cause a lot of pain for anyone who has borrowed non fixed debt.
2. Overly Optimistic Cash Flows
Lack of cash flow is the elephant in the room on these deals. It results in undercapitalized reserves which increase with rising debt costs.
Most syndicators go into real estate investing for the short term. Hoping a current negative or zero cash flow situation will quickly turn by rehabbing the property then they can sell it for more than they purchased it for. This works when prices are rising and interest rates are stable, but a sale price in investments is solely dependent on the cash flow the property produces. So it doesn’t matter if you rehab a project, and increase the rents. If the buyer’s debt has gone up monthly based on the new rates, that will directly play into the cash flow the property kicks off once purchased, hence the sale price you can get for it.
3.Falling Prices and Demand
During good times, home prices soar and real estate investors cash in on fixer-uppers, hoping for a quick flip and profit.
In fact, from December 2019 to June 2022 (as COVID spread), many took advantage of historically low-interest rates at the time to buy homes, causing demand to soar and prices to surge 45% during that period.
However, prices have started to correct dramatically since. Home prices are decelerating at the fastest rate in over a decade across major markets in the U.S., and homebuyers are increasingly backing out of deals (a record 16% in July 2022).
Bullish price hikes during the pandemic also priced out too many potential buyers. During Q2 of 2022, only 16% of Californians could afford the median home price of $883,370 (down from 23% in 2021).
While prices aren’t likely to drop as they did in 2008, buyers are increasingly waiting on the sidelines for better deals, causing many fixer-uppers to sit on the market unsold.
4. They’re stuck waiting
Due to declining prices, many investors are also unwilling to let go of their investments, hoping for prices to bounce back or interest rates to fall.
Buyers are also sitting on the sidelines waiting, causing prices to further drop.
With both buyers and sellers playing chicken, more downward pressure is likely, causing investors that were overly optimistic, over-leveraged, or purchased a bad deal to potentially go broke.
Until Next Time,