Increased interest rates have created an interesting dilemma for the potential real estate investor -- especially in the area of apartment investments. Is now the time to buy, or not?

On one hand as interest rates go up it makes it more difficult for investors to make deals pencil. On the other hand, most investors know that in some key states populations are growing resulting short-term shortage of housing. (see my article #183, “What Makes Investing In Real Estate a Valuable Proposition” for additional information on this.)

In markets with this housing shortage, rents will be forced up as the shortage looms ahead. The increased demand for rental housing will come from three major places: 1.) the increase in students graduating from colleges (the echo-boom or baby boomers kids), 2.) the increase in immigration and the growth of immigrants families, and 3.) as interest rates increase a few people will lose their homes to foreclosure. These foreclosures most likely would result from having purchased homes with no money down, and/or made interest-only payments, and not having the ability to pay increased mortgage rates.

This press release from RealtyTrac illustrates this point.

In addition, the cost of construction is soaring in many markets. Land close to economic (city) cores has become very expensive. In Portland, the Urban Growth Boundary has created an artificial shortage of land and made it more attractive to build condominiums. This has generated a condominium boom. This new construction boom has also encouraged developers to buy apartment buildings and convert them into condominiums.

These key items could encourage buyers to make risky purchases of apartment investments by gambling that significant increases in rent (due to apartment supply shortages) will offset increases in interest rates and any negative cash flow concerns. The pressure on interest rates will force employees to look for higher paying jobs, or push for significant pay increases to keep up with rent increases.

What does the future bring?

If there is overbuilding of condominiums, the overage will be converted to apartments/rentals, albeit at high rental prices, until the market turns. There will also be a demand for apartments at median income levels, and an increase in foreclosures of homes and condominiums that will start as a trickle and increase in flow if interest increases exceed one percentage point in 2006.

Again the dilemma is to buy or not to buy. I say buy -- but very carefully and do not over-leverage. If you have it, put more money down. Rents will increase. New apartments built with unsubsidized money will be more expensive to rent than renovated apartments built 30 years ago.

On a recent trip to Israel, we were trapped on a road at the Dead Sea in a flash flood. There I meet an Israeli real estate investor who reminded me to look at the big picture. He suggested that the current birth rate drives future apartment development, and he also pointed out the very low birth rates in Europe, Eastern Europe, Australia, Canada, USA, Singapore, Japan, Korea, China and Singapore versus higher birth rates in the rest of the world. There are two ways to look at this:

  • Those countries with low birth rates will have less demand for apartments
  • Immigrants from high-birthrate countries will overwhelm those low birth countries and create a demand for housing similar to what has happened over the past 10 years in the USA. This means that immigration policy is critical to the long-term success of real estate investments.
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