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The Federal Reserve has cut rates by 0.25%, and the message emanating from chairman Jerome Powell appears to be, “Enjoy it while it lasts.” With inflation proving more stubborn than anticipated, the Fed’s soft landing has encountered a few bumps on the tarmac.
Powell admitted that the decision to continue rate cutting was a “closer call” than he had imagined. As for the anticipated glorious year of rate cuts ahead, Powell was circumspect, indicating that there would only be two rate cuts in 2025.
Even Two Rate Cuts Could Be Wishful Thinking If Inflation Doesn’t Drop
So here we are, three Fed rate cuts in, and mortgage interest rates have not changed much since the cuts started. With only a couple more on the horizon and the fear that President-elect Trump’s proposed tariffs could increase costs, as well as worries that a boosted economy could see inflation rise, real estate investors have a few months of reckoning and hand-wringing ahead of them.
As Powell spoke to reporters, one question dominated: If he thinks inflation will remain stubborn next year, why is the Fed still cutting rates? Powell’s response was, basically, that future rate cuts aren’t guaranteed. In other words, even two cuts next year could be wishful thinking.
Cutting rates is generally only done when inflation is comfortably low, so the fact that the Fed is still cutting them should be a good sign. However, the limited cuts ahead won’t bring much solace for real investors hoping for 4% to 5% interest rates, allowing them to refinance rental properties to cash flow. It also means that homebuyers will likely be limited in their purchasing options, causing flippers to slam on the brakes amid a limited buyer pool.
Don’t Rely on the “Low-Rate Guy”
Although the incoming president has previously touted himself as a “low-rate guy,” don’t rely on him or anyone else to magically lower rates next year. We would all be low-rate guys if given the chance. The problem is that the economy and inflation are hard to tame, especially with a fractious geopolitical climate. And who could have predicted the pandemic?
The incoming government faces the challenge of growing the economy while keeping interest rates in check. For real estate investors, the Fed’s message is a reality check: Give up the dream of low rates and get comfortable being uncomfortable around a 6% to 6.5% interest rate.
What Should Investors Do Now?
Given these stats, the options favor long-term investing over the short term. Many of the strategies pre-pandemic are not feasible today. Here are a few that are:
1. Look for value-add deals with below-market rents.
Commercial real estate is valued based on the cash flow it generates. The fallout from the rate volatility of the last few years has been multifamily buildings that were overleveraged based on the assumption that rates would stay low. When a renovation can’t be completed, tenants leave, and a downward spiral occurs with banks willing to offload deals, sometimes for pennies on the dollar. Look for undervalued deals, fix them up, and create cash flow and equity.
2. Get FHA/203K loans for personal residences and enjoy big tax advantages—over and over again.
This is an old-school method, but it’s been tried and tested. I did it myself when rates were 7.5% years ago. Find a fixer-upper that you plan to live in an appreciating market, get a 203K loan to fix it up with an FHA 3.5% down payment, and live in the home for at least two out of five years.
When you sell the home—assuming it has appreciated significantly—the IRS allows you to forgo paying capital gains taxes on up to $250,000 of that gain from your income or up to $500,000 of that gain if you file a joint return with your spouse.
When this strategy is employed on a two-to-four-unit building in which you reside, not only will your tenants pay your mortgage, but you could qualify for a more expensive home and thus enjoy higher profits (although only the unit you live in is exempt from capital gains taxes). Rinse and repeat, utilizing the profits from each sale to fund other deals, and you’ll be on the way to financial freedom.
3. Buy in good neighborhoods for long-term holds and equity appreciation
B and B+ neighborhoods appreciate much faster than less desirable ones. Buying a rental in these neighborhoods might not bring you cash flow, but it will give you equity, offer tax advantages, and allow you to access capital in years to come when and if rates do come down or you wish to deploy the equity elsewhere. This won’t get you rich quickly or allow you to leave your job, but it’s a secure way to increase your net worth without much risk.
4. Boost cash flow through corporate short-term rentals
Business executives would much rather stay in a comfortable Airbnb than a hotel, and their companies are willing to spend big money to make that happen. A short-term arbitrage acquaintance recently leased a single-family home for $10,000/month in Pittsburgh to Netflix execs filming there. These clients are like rocket fuel to your rental business and spike your cash flow two or threefold compared to a regular rental.
5. Refinance or modify your loan
If you are facing financial difficulty due to a high interest rate, a loan modification might be worth looking into. A lender only approves these if you are behind on your mortgage, and you would need to pay a percentage of the default amount back upfront. However, if you are approved, you could enjoy the freedom of a low interest rate to help you get back on track.
If you’re not in default, consider refinancing to an interest-only or ARM to help you weather the storm.
6. Consider government grants and loans
There’s never a good time for a housing crisis, but the issues are compounded in an era of high interest rates. Fortunately, the government has many programs aimed at alleviating the problem. If you own a rental or want to buy one, you can get grants and low-interest loans to buy and renovate your property if you intend to use it to house vulnerable community sectors.
Final Thoughts
While there will always be successful flippers and wholesalers, those sectors of real estate investing have fallen significantly in the last year as rates and house prices have remained high. For most investors, the current interest rate scenario and the generally high cost of homes mean that long-term buy-and-hold strategies will come far more into play.
You can still increase your cash flow through loan paydown and yearly rent increases, but it might take longer than you had hoped. High rates generally call for conservative, traditional investment strategies. They are not flashy, but generations of Americans have gained tremendous wealth through them, and there’s no reason they won’t work today.
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