Understanding How Interest Rates affect Real Estate Returns

With interest rates at historic lows, it’s easy to forget the impact that higher rates can have on property returns. What exactly does it mean to your investment if interest rates go up or down by a fraction of a percent? It may not sound like a lot, but small changes in interest rates can have meaningful impacts on your total returns.

Below we’ll highlight the impact of changing interest rates on investment returns for a theoretical property. For this example, we’ve assumed a $100k property generating a 7% cap rate (defined as net operating income divided by cost). We’ve also assumed a 25 year mortgage with an 80% loan to value in order to compare the impact on both pre-tax and and post-tax returns. The measure we’ll be using to compare returns is the internal rate of return, or the IRR. For those unfamiliar with the IRR measure, it’s the annualized effective compounded return rate.

*Assumes a marginal tax rate of 35%

(Note: the above table refers to U.S. mortgages. Canadian mortgages use semi-annual compounding which makes the numbers very slightly different. A table for Canadian mortgages is included below)

As our example illustrates, a small half percent increase can have a significantly larger impact (in this case an over 2%) on the investment’s returns. So what can or should you do about it? Well the first thing you should do is quantify the impact of different rates on your investment (thankfully, the SpendTree tool allows you to do just that). This will help you to decide whether you should fix your interest rate or leave it floating (variable rate). In one of our future blogs, we’ll explore which type of interest rate is better for you.

Canadian Mortgages

*Assumes a marginal tax rate of 35%