Whether you realize it or not, much of our world as investors is dictated by interest rates. Not just because it changes the terms we get on that commercial mortgage loan or the cash on cash return we receive from our passive real estate investments, but because how it changes influences our overall economy and what we choose to invest in as well. 

If you didn’t know, short term interest rates are manipulated by the Fed. When you hear “interest rate hikes”, that’s what’s being talked about. The interest rate set by the Fed is essentially saying “we are currently willing to buy unlimited quantities of money at this rate.” But how do these manipulations work, why do they do it, and what’s the takeaway for real estate investors? Read on to get the answers to these questions (and more). 

We had the opportunity to interview former Federal Reserve Trader and author of Central Banking 101 Joseph Wang to get a schooling in how our Federal financial system actually works. He shared so much wisdom that we felt it was important to recap the answers to the top questions that investors like you asked about this macroeconomic topic. So here are the top 5 questions and answers about federal interest rates plus a recap of the key takeaways for why real estate investors should care. 

What are 10 year treasuries and why would the Fed now stop buying them?

U.S. Treasuries are like a dollar bill that pays interest. Yes, they are also printed by the government just like dollars as well. But they grow with interest. “If you are a big bank, you can’t just put trillions of dollars in the bank”, says Joseph. This is why large banking institutions, insurance companies, and even other country’s central banks purchase very liquid, secure assets like Treasuries instead. 

As we all know, the government did some emergency spending last year (around $3 trillion dollars worth). When this happens, the government actually issues debt in the form of Treasury bonds and the Fed buys it.

Until recently, the Fed was buying about $80 billion worth of treasuries every month. This increases the supply of money in the economy and keeps interest rates low in order to give the economy a boost. What they then realized is that the economy was actually doing ok and no longer needed this emergency stimulus. In fact, this stimulus was leading to the high inflation we are experiencing now. In order to combat that, the Fed will try to raise interest rates by essentially stopping the purchase of Treasury bonds to reduce the money supply. 

What is the Fed really trying to do by raising rates?

The most recent rate hike is a measure to combat inflation. High inflation rates are viewed as a negative by the public. The way to combat inflation is to raise interest rates and lower the supply of money in the economy. In addition, the Fed is really trying to impact longer term rates (like the 10 year Treasury rate) because they believe there is a big asset bubble currently happening. Longer term rates are more difficult to directly manipulate. 

Ultimately the rate increases will impact markets like the stock market because with less investor confidence in the economy this market becomes more volatile. To some level, the real estate market will also be impacted via increased mortgage rates but as an investor, you (or your syndication team) should have ample reserves built into their business plan to cover this increase in costs.

What will happen to interest rates this year (2022) and what will be the impact?

The good news is that the Fed will notify the public that they are planning to raise rates far ahead of when the actual rate hikes will take effect. The market tends to react before the rates are actually even raised based on these “hints.” We already expect that the Fed will do a few interest rate hikes throughout the year. “The Fed is first and foremost about employment and inflation, and inflation is too high,” says Joseph. His view is that the increases will probably be more aggressive than expected.

So what will the impact be? Rates will become more volatile. This is part of the Fed’s plan though, because when they sell mortgage assets, this creates rate volatility. We’ve already seen the impact on raw material markets like lumber, oil, etc. As a real estate investor specifically, the impact will ultimately be on your loan rates. Now is the time to be conservative and underwrite any new deals with higher reserves than you might have previously in order to accommodate any increases in rates that may come in the future.

Should we even have a Federal Reserve?

From Joseph’s perspective, “It’s not whether we should have a central bank or not, but what kind we should have.” In his view, having one is better than not having one. He thinks of it like an evolution. In the beginning, no one had central banks. Now they do. Why? Because every now and then, before we had central banks, we would have financial panics where people would take everything out of the bank and then banks would fail. 

Having a central bank provides a resource to help banks out during these times, especially when their liquidity is low due to larger economic events like wars. But today, central banks do much more than just help out banks. They get involved in policies related to topics such as climate change. “Should they? That is the question,” he asks.

How will these interest rates impact the crypto market?

According to Joseph, the real topic that cryptocurrency investors should be concerned with is regulations vs rates. Regulation will come from the SEC. The Fed does not get involved in this area. What will be interesting is to see what happens with private centralized crypto banks and the government. 

“The government won’t like having competition so we might not have other options like we do today” if the government decides to dive into the crypto world. Just look at what happened with bitcoin in China after they came up with their own digital currency, warns Joseph.

Key Takeaways for Real Estate Investors

Now that you have the knowledge, your next question might be what to do with it. If your brain hasn’t exploded yet, here are some real actions you can take as a real estate investor based on this discussion: 

• Regardless of what type of real estate assets you are investing in, the overall takeaway is to be more conservative in your approach

• If you’re a flipper, you should anticipate that the value of the homes you buy won’t go up as aggressively as they have been recently. Make sure you are buying houses below market rate so that you can continue to get a return.

• If you’re active in the multifamily space and focusing on value add deals, be sure to underwrite very conservatively and have extra reserves in place that you can tap into if your loan rates increase. Don’t get over leveraged.

• If you’re a passive investor, be sure to vet any new value add deals with a lens on how aggressive the underlying assumptions built into the pro forma that will impact your returns are and ensure they are on the more conservative end. Also, be sure to find out how much capital reserves the sponsorship team plans to keep in place in case of any increased debt servicing that has to be taken care of due to increased interest rates.

If that got you hooked and you’re ready to dive deeper into the macroeconomic world, get out your No. 2 pencil and watch the entire recorded interview with Joseph. You’ll be surprised at what you can learn in just an hour.

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