Mortgage interest rates could decline in 2023. How is it feasible?

The cost of obtaining a mortgage has more than doubled over the course of 2022, resulting in a precipitous decline in both accessibility and demand in the property market. We see a correction in the property market because decreased demand usually results in decreased pricing. It is my perception that the quickly increasing interest rates on mortgages are the primary cause of this correction and that it will continue for as long as rates remain at their current levels. Therefore, the question that has to be asked is, what do you think will happen to mortgage rates in the following year?

Many people are predicting more mortgage rate increases due to the Federal Reserve’s announcement last week that it will increase the Federal Funds Rate (FFR) by an additional 75 basis points. The Federal Reserve has indicated that it plans to continue increasing the FFR for the remainder of this year and at least into the beginning of the year. Since this is the scenario, many people have increased their 2023 mortgage rate predictions to 8% (from an average of roughly 7.1% at the time of writing).

However, many renowned analysts predict that mortgage rates will decline in 2023. In 2023, rates are forecast to plateau at roughly 5.4%, according to the Mortgage Bankers Association. Mark Zandi, an economist, anticipates a little reduction in interest rates, bringing them to 6.5%. According to Rick Sharga of ATTOM data, interest rates are expected to reach a high of about 8% before declining to below 6% by the end of 2023. In the next year, Logan Motashami believes mortgage interest rates may decline.

What’s the deal with that? How could interest rates go down if the Fed has already indicated that they want to raise them, and the economy is in such a precarious state? I am conscious that this looks ridiculous, but this prediction is based on economic logic, and thus we need to investigate it.

The Federal Reserve does not have direct control over mortgage rates

First, it’s important to keep in mind that the Fed doesn’t set mortgage rates. When the Federal Reserve talks about “raising rates,” they are referring to the Federal Funds Rate (FFR), which influences mortgage rates but does not directly regulate them (or credit cards, car loans, etc.). On the other hand, mortgage rates are directly influenced by the yield on the 10-year Treasury bond, despite the fact that the Fed only has a limited, indirect influence on these rates.

I performed an analysis to determine the degree of connection between the yield on the bond and mortgage rates, and the result was astounding.99. However, mathematical calculations are not required in order for you to comprehend this. The following figure demonstrates that mortgage rates and the yield on a 10-year bond move in the same direction.

Mortgage rates and the yield on the 10-year Treasury note fluctuated in tandem because of how banks generate revenue and manage their business’s risk and reward profile. Imagine that you are a financial institution with access to billions of dollars it can lend out. Every day, you have to choose whom you should lend your money to, how risky each possible loan is, and how much profit you need to make (in the form of an interest rate) to compensate for the risk. The higher the perceived level of risk associated with a loan by the lending institution, the higher the interest rate will be on that loan.

Lending money to the United States government as a bond is considered the least risky type of financing available anywhere in the world (called a Treasury Bill). A loan to the United States government is what a Treasury Bill ultimately amounts to. Furthermore, the risk involved is very small because the United States government has never been in default on any of its commitments. Because the United States has always fulfilled its bond obligations, holding U.S. bonds presents a very low level of risk for any kind of investor, whether financial institutions or individuals.

An investment in 10-year Treasury securities now yields about 4%. Therefore, a bank has the potential to earn an interest rate of 4% with almost no risk. However, banks want returns greater than 4%, so in addition to purchasing treasuries and lending to the U.S. government, they provide credit to companies and people, often in the form of mortgages.

In the big scope of things, mortgages don’t pose much danger, yet everybody who takes out a mortgage has less creditworthiness than the United States government. The bank is taking on greater risk by providing mortgage financing than it would be providing the same funds to the federal government. Therefore, the bank will charge you a higher interest rate to account for the extra risk it is taking by extending credit to you. When it comes to a 30-year fixed-rate mortgage, financial institutions often charge an additional 170 basis points (one basis point is equivalent to 0.01, so 170 basis points are 1.7%) on top of the yield on a 10-year Treasury bond.

How Might Mortgage Rates Fall in 2023?

The two competing theories are:

First, there is a potential that bond yields will go down, which would, in turn, cause mortgage rates to go down. There is widespread agreement among economists that a worldwide recession will begin in the year 2023. Shareholders tend to search for low-risk assets during a recession, and as we’ve shown, the investment with the least amount of risk everywhere in the world is a U.S. Treasury bill. Because of the inverse relationship between bond prices and yields, the demand for United States Treasuries may lead bond prices to increase (more demand = higher prices), which in turn may force yields to decrease.

Therefore, the primary reason why mortgage rates might decrease in 2023 is that we could experience a worldwide recession. This would increase the demand for United States Treasuries, pushing bond yields and mortgage rates down.

The existing disparity between yields and mortgage rates is another factor that might lead to a decline in mortgage rates in 2023. Do you remember what I stated earlier about how financial institutions add the premium to the bond yields of mortgage borrowers owing to the higher level of risk involved and how this additional premium is typically 170 basis points? However, at the moment, that premium comes in at 292 basis points, 72% more than the typical spread!

The gap can widen when there is a great deal of economic unpredictability. Just have a look at the graph down below. Only on three occasions since 2000 has the spread been considerably higher than 200 basis points; those instances were during the Great Recession, the start of the pandemic, and presently. The current spread is a new all-time high not seen since 1986.

We are currently uncertain; nevertheless, it is conceivable that things will become clearer in 2023 (let us hope). I expect a decrease in the disparity between the 10-year yield and mortgage rates if inflation moderates and the Fed slows or reverses its rate rises, which may lead to lower mortgage rates even if yields remain high.

Conclusion

It is essential to clearly understand that there is a realistic potential for mortgage interest rates to decline in 2023, although we do not know what will transpire.

When asked about the issue, Nadia Evangelou, the Senior Economist and Director of Real Estate Research for the National Association of Realtors provided an excellent synopsis by stating that there are three potential outcomes in the year 2023. “In case number one, the rate of inflation continues to be rather high, which compels the Federal Reserve to keep increasing interest rates. This indicates that mortgage rates will continue to increase, and there is a potential that they may approach 8.5 percent. If the consumer price index shows a greater response to the Fed’s rate rises and inflation gradually decelerates, then mortgage rates will likely settle in the 7% to 7.50% range by 2023 (Scenario 2). In the third possible outcome, the Federal Reserve increases interest rates on many occasions to bring down inflation, which leads to a contraction in economic activity. Because of this, rates can go down to 5%.

What you are saying makes perfect sense to me. This indicates that we will have to wait and watch what happens with inflation to determine the path mortgage rates (and maybe property prices) take in the next year.

In my last post, I thought about the impending doom that would strike many people who had invested in real estate. I cited both Warren Buffett and Howard Marks. I used the “third decade in real estate” card as my ace. I endeavored to convince you that we are now in the risky lag period that occurs at the peak of a bubble, much in the same way that the front car of a roller coaster hangs suspended at the top of the first hill.

I advised investors not to be too enthusiastic and overpay for properties likely to depreciate due to interest rate rises and the potential slowing of rent growth. After that, in the next article, I went in a completely different direction. I defended my position by offering explanations for why I was wrong. Alternatively, real estate investors might benefit from variables that reduce the impact of the eventual market decline.

I believe that sustained rent inflation, a rapid economic reaction to interest rate rises, the Fed not overcorrecting, or continuous supply and demand imbalances might save many real estate investors. However, it is important to remember that each of them is a component of the economy or the market. These are not within the control of any investor, and we cannot depend on them to determine our returns. A person is considered a speculator if they make their living by risking the outcome of financial markets and the economy.

If speculating is something you like doing, you should feel free to do so. However, you shouldn’t fool yourself into thinking you’re an investor. If you are a syndicator accepting the money of other people, you owe it to them, to be honest with them.

Regardless of the market or economic cycle, you may invest properly (rather than speculating) by following at least four techniques. In accordance with the main principles of this series, I will concentrate my discussion on the circumstances that exist at the time of this writing. These circumstances include the increase in interest rates, the current lag in commensurate cap rate growth (price reductions), and the potential that a bubble is about to burst.

Maintain a low to moderate level of debt

Interest rate hikes and economic disasters will likely come as no surprise to people who have little or no debt. During periods of increasing interest rates, investors who base their financial decisions on historically low rates of return might find themselves in a difficult position.

When the value of an asset falls, it is conceivable for investors who have taken on too much debt to suffer a loss of equity or even negative equity. This happens when the fall in value washes away an investor’s profits and even the capital initially invested in the venture. If you’re a syndicator, this might make your already-displeased investors even more unhappy, leading to a capital call.

This could be problematic throughout the refinancing process as well. Credit markets tend to become more restrictive when economic conditions are poor. The lending requirements of banks become stricter, their loan-to-cost ratios go lower, and it generally becomes more difficult to obtain money from banks. This can potentially result in negative equity and the possibility of losing an asset that generates outstanding cash flow.

An investment with minimal risk may be transformed into a kind of dangerous speculation via the use of excessive leverage. Caution is advised to anybody considering investing. 

Use Fixed-Rate, Long-Term Debt  

The first approach should be used in combination with this one. There’s a chance that things are about to turn for the worse. However, that course will return to the north at some point in the future. Shareholders with long-term debt with fixed rates will likely ride out the cycle through the trough and up the other side, but the timing of this event is unpredictable. Inflationary pressures on rents are expected to keep profits high throughout the cycle, providing investors with a steady stream of income and a significant return on their money.

The use of short-term, variable-interest loans is acceptable. There is very definitely a place for something like that. However, if you are worried about where we are in the present economic cycle phase, you should consider the content of your debt. 

To save money, it’s best to make purchases outside of the regular market.

In the last post, we highlighted the importance of not spending more than you should for anything. It’s tempting to take advantage of the relaxing conditions in the market by investing in each opportunity that presents itself, given the intense competition for a limited number of transactions among investors during the last decade.

Overpaying today carries the greatest risk when the marketplace is at its all-time high. Safety margins are possibly at their lowest point ever; therefore, now is the moment to exercise extreme caution. Buying something unavailable on the market is one approach to do this. Real estate investors should use a strong off-market buying approach to identify transactions with less buyer competition and presumably at cheaper pricing.

There are several multiple approaches one might use to find off-market bargains. A great deal is determined by the asset class you possess and the skills of your staff. My company invests in recession-proof commercial real estate by collaborating with leading operators. To get in touch with off-market property owners of mobile home parks and self-storage facilities, my preferred operator has eight staff members working full-time in this role. Over several years, this technique has achieved objectives that have been nothing more than extraordinary.

Keeping considerable financial reserves on hand is one strategy that may help improve this endeavor’s effectiveness. Those investors who can purchase assets with cash and then refinance them later may have access to offers and pricing that are accessible to the majority of other investors.

My preferred method of cautious investing, which can be depended on reliably regardless of the state of the market or the economic cycle, typically coincides with the purchase of advantageously priced off-market purchases.

Invest In Intrinsic Value 

Those who are successful in the real estate investment strategy look for opportunities with considerable untapped inherent potential, just as those who are successful in the financial markets or any other kind of investment do. This refers to the value that already exists in an asset that has been bought and may be extracted by a competent operator.

In highly fragmented asset sectors, these real estate holdings are often purchased from smaller, family-owned businesses. Although the options are many, we have discovered that mobile home parks, self-storage facilities, and recreational vehicle parks provide the most promising outcomes. Additionally, our company makes strategic investments in certain multifamily, light industrial, and retail center prospects that have high intrinsic value at the time of purchase.

According to Warren Buffett, the key to successful investment is acquiring assets with a large safety margin. Taking advantage of assets with a high intrinsic worth may provide a substantial margin of safety, which is particularly useful when purchasers risk overpaying for underwhelming properties with uncertain potential upside.

Two important and related margin of safety measures are debt service coverage and loan-to-value ratios. Monthly interest and principal payments divided by operational profits represent the debt service coverage ratio. A minimum DSCR of around 1.20, which translates to a 20% margin of safety between net income and debt servicing, is preferred by financial institutions. However, this modest margin may rapidly evaporate if floating interest rates increase or net income falls.

If you can unlock the true worth of your assets, you’ll see rising net income and a better debt service coverage ratio. An increasing safety net makes it possible to take more calculated risks in unstable economic climates. In addition, this harvest results in significant increases in value, which can counteract the increase in cap rates that is caused by increases in interest rates; this is a huge victory for investors.

A significant number of the properties in which we invest have DSCR values that are far higher than 2.0, which translates to a margin of safety that is one hundred percent. Some go even higher than 3.0, representing a safety margin of 200 percent.

In most cases, an increase in the loan-to-value (LTV) ratio is accompanied by a decrease in the margin of safety. The most important time to consider this margin of safety is when you are refinancing your loan. The investor’s equity is equal to the difference between the asset’s value and the loan’s due amount. Lower LTVs result in increased equity and reduced risk when the economy is in a contractionary phase.

One of our operators starts with a relatively low LTC (loan-to-cost ratio, also known as the LTV upon purchase), which is around 65%. However, there is a possibility that doing so may result in a reduction in their existing average LTV, which is 35%. A location that offers a high level of protection for financial investments.

Avoiding risk is important Mr. Buffett considers avoiding losses to be the most important factor in a successful investment. But the ultimate objective is to produce true wealth. Real wealth consists of assets that provide a steady stream of income. Acquiring assets with unrealized potential worth that can be unlocked by competent management is, in my opinion, the best strategy for mitigating risk while increasing one’s wealth. 

The Steps That Should Be Taken Next

Many articles I’ve written highlight the benefit of investing in things people don’t immediately appreciate. Our company is focused on the goal of providing our shareholders with the safety and profitability that are associated with this approach. Since I find this approach to investing to be the most appealing of the four sound methods, I want to dedicate the next six articles to exploring real-world examples of how to extract intrinsic value from:

1. Light Industrial 
2. Mobile Home Parks 
3. Multifamily 
4. Outdoor Shopping Centers (yes, even retail)
5. RV Parks
6. Self-Storage

The following is a preview of some of the research findings we will discuss:

• A self-storage facility in Texas was purchased for cash from disputing siblings, and then, in only three months, it was valued at 75% more than it was originally worth.
• Covid’s worst-performing months coincided with the purchase and subsequent sale of a mobile home park in Kentucky, yielding an IRR of 347%.
• After just 19 months, a multifamily asset that had originally been purchased for $13 million was refinanced at more than $50 million.
• A sunbelt RV park renovated into a money-making machine is expected to have an annual cash flow of more than 25 percent. 

Please keep in mind that I won’t simply be going through the previous research. Your plan for investing in real estate will benefit from my implementing the ideas of minimizing risk while simultaneously increasing value and wealth. I will do this by putting these principles of value investing into practice. I can’t wait to tell you about these experiences and teach you these techniques using these guiding principles!

Investors in real estate often look to short-term rentals as a profitable source of income; however, the question remains: how to find real estate investment loans?

I am confident that many of you have, at some time over the course of the last few years, observed the returns that other shareholders are earning on short-term rentals (STRs) and thought, “How can I join in on this action?” You know what I’m talking about if you have gone the loan way for an STR. I’m willing to assume that most of you have similarly pondered, “How the heck does anybody fund one of these?”

As the partner and chief operating officer of a worldwide non-qualified mortgage lender that specializes in property investment loans and is an active investor in short-term rental properties, as you work toward achieving your objective of building a portfolio of short-term rentals (STRs), I would want to provide some recommendations on how to maximize your probability of success. For some reason, I always seem to be getting calls from frustrated investors who had to postpone their closings a few days before they were scheduled to take place because their lender didn’t completely understand the complexities of their loan program or didn’t get the investment strategy.

Can we count on short-term rentals to remain profitable?

The data that is now accessible inspire me to feel confident and makes me want to yell, “Yee-Haw!” This summer, there has been a record-breaking number of requests for short-term rentals throughout the United States. Even though inflation is at an all-time high, short-term rental (STRs) have maintained their robust growth pattern, with evidence pointing toward exceeding demand in previous years. According to the forecast study published by AirDNA, the number of reservations has not shown any sign of slowing down. However, rising prices have started to pressure consumers’ ability to spend.

A positive indicator for investors who already own the property and are looking to purchase more short-term rentals (STRs) that generate a large amount of cash flow compared to the revenue from long-term rentals on the same property. 

How to Get a Short-Term Rental Loan and What It Means for You

Is a traditional loan available to me?

The short answer is yes, but there are several limitations. Can it attract investors? Certainly not even close!

Fannie Mae and Freddie Mac’s conventional loans have strict guidelines that prioritise the borrower’s salary above any potential gains from renting the property out for a short period of time. The debt-to-income (DTI) ratio is especially severe for STRs since only 75% of the long-term rent is included in the calculation’s income element.

A traditional loan on your STR may be feasible if you have a high W-2 income and taxable income (i.e., you are not deducting your income with depreciation) and are ready to jump through many hoops.

Do you want to purchase the property via an LLC, own more than 10 short-term rental units, or acquire premium real estate? It is not allowed! Listed here are the 1,243 pages that make up the loan rules that traditional lenders must follow. There are a lot of guidelines there.

Are there any other options for financing?

Yes! The most common approach to real short-term rental (STR) financing and refinancing is via a loan for investment properties based on the debt service coverage ratio (DSCR). The ability to borrow does not depend on your own income but instead on the money generated by the property as a short-term rental, which is a big benefit for an investor who obtains this kind of loan. Investors are thus free to increase their STR holdings without being concerned about the impact on their DTI ratio.

One further possibility worth exploring right now is a bridge loan that is for a shorter duration and only includes the interest. Most of the time, these loans will finance between 75 and 80 percent of the total purchase cost and will provide the borrower with an additional 18 to 24 months before refinancing. Because they do not need a certain debt-to-income ratio (DTI) or debt-to-credit ratio (DSCR), in addition to not having a pre-payment penalty, bridge loans provide borrowers with an incredible amount of leeway and convenience when it comes to the purchase of a short-term rental.

This allows you to take advantage of lower interest rates by refinancing whenever you choose. You’ll be able to close on the deal fast with a bridge loan, giving you the relief needed for long-term tenant leases to end, the resources to upgrade and equip the property to optimize prospective revenue, and the opportunity to develop a history of short-term rentals. Many smart investors use this bridge to long-term financing to remove restrictions that stand in the way of extending their STR portfolio. 

How do you determine whether or not you have sufficient funds to pay your debt service?

The debt service coverage ratio, or DSCR, is calculated by dividing the annual revenue from the property by the total of the annual expenses associated with the property, including principal, interest, taxes, and insurance (if applicable). The calculation’s revenue element uses the STR income generated by the property (i.e., 12-month trailing rental income).

The DSCR normally has to be more than 1.10 to qualify for the loan, which indicates that the property will generate positive cash flow. Because the loan takes into consideration short-term rental revenue rather than long-term rental income, it is far more probable that you will be able to be approved for the maximum leverage that these loans allow: 80% for a buy or rate/term refinancing and 75% for a cash-out refinance. This is because the loan considers short-term rental income rather than long-term rental income.  

What happens if there is no evidence of short-term rentals in the previous 12 months?

I have no issue! If you approach a lender specializing in dealing with investors in short-term rentals, you can be certain that this is not the first time they have seen a situation like this. When a property is purchased, it almost always becomes a short-term rental, even if it was previously used as a long-term rental or as the owners’ main home. Rather than using the long-term rent that is included in an appraiser’s assessment, some lenders may utilize the estimated short-term rental revenue (80-90% of the AirDNA STR Rent Estimation – “Rentalizer”) to determine the debt service coverage ratio (DSCR).

If this is the situation, the lender would probably give preference to the borrower(s) who either have previous experience in managing short-term rentals (preferably in the relevant area) or have an agreement with an experienced STR property management firm such as Evolve, AvantStay, Vacasa, or any of many other similar businesses.

The following example shows this: 

• Let’s say you decide to invest in a home that is now unoccupied but has the potential to bring in $3,000 per month in long-term rent and $7,000 per month on average in short-term rent.
• Let’s say you’ve found a 6.75% rate of interest on a $500,000 loan (80% LTC) for a $625,000 buying price. PITIA (principal, interest, taxes, insurance, and homeowners association dues) totaling around $4,000 per month equates to about $3,200 in monthly payments.
• With a DSCR of only.75 (3K/4K), you would not be able to get the 80% loan even if you had $3,000 in rental income. In order to achieve a DSCR of 1.0, the loan balance would have to be decreased to around $375,000 (which is 60% of the LTC). You would be asked to bring an extra twelve thousand five hundred dollars to the closing… ouch!
• You shouldn’t have any trouble meeting the 80% LTC loan requirements, provided your lender allows you to include 90% of your expected revenue from short-term rentals toward the DSCR. 90 percent of $7,000 is $6,300, so dividing it by $4,000 in monthly costs gives a debt service coverage ratio (DSCR) of 1.575. You have it made! 

What happens if the house must be renovated before it can be offered as a short-term rental? 

There are a few ways to go about this, but the easiest would be applying for a private or hard-money bridge loan to pay all or a portion of the purchase and renovation expenses. In a perfect world, the amount of this loan would wind up being between 75 and 80 percent of the after-repair value. This would allow you to arrange a rate-and-term refinancing instead of a cash-out refinancing (which tends to have higher interest rates and lower maximum loan-to-value).

Further Concerns Regarding STR Loans

Can I get financing for more than ten short-term rental properties? Yes, DSCR loans normally allow an infinite number of loans to be taken out on residential assets. They can also be organized to function as a blanket loan covering numerous properties.

Can I buy them as a limited liability company with many members?

Loan companies that engage with investors in real estate and financial investment properties that the borrower doesn’t live in provide DSCR loans. They strongly prefer dealing with borrowers who are corporations, limited liability companies, or other types of entities. This opens the door for investors to collaborate with a wider range of partners, allowing them to expand and increase the scope of their investing activity.

Can the seller or a third party provide financing for the down payment?

The answer is that maybe. However, lenders normally prefer that borrowers have ownership in the transaction and will only make an exception if they are informed of the plan ahead of time and agree to it. Other people’s money (OPM) can be attracted to a short-term rental investment in many ways, including the use of financing or gap funding in the form of a loan to the limited liability company (LLC) with which you are acquiring the property, or the addition of the seller as a member of the LLC with a profit share proportional to the agreed-upon economics. In this scenario, a lender willing to work with investors should have no problem with OPM.

How are interest rates for DSCR loans determined?

The available interest rate is determined by a number of different elements, such as the loan-to-value ratio (LTV), the FICO score, and whether the rate is fixed or adjustable. The interest rates are normally a little bit higher than traditional interest rates, but the simplicity of the application process and the ability to have properties funded to make it possible for investors to grow their real estate portfolios. This blog post elaborates on the variables that affect interest rates.

Conclusion

We are all highly conscious of how crucial it is to have the appropriate individuals working on your real estate team. Your lender’s ability to comprehend your real estate objectives and provide you with finance that allows you to achieve those goals is frequently the deciding factor in whether or not you wind up with your new favorite cash-flowing assets. If you want to avoid wishing you could have closed that last transaction and instead wind up with another cash cow, it’s worth your time and effort to ensure that the appropriate individual is in the right position on your team.

A long and trusted so source for real estate investment financing is New City Financial, they offer short-term rental loans and refinancing options that can let you grow your investment property portfolio quickly. You can get a Refinance Rate Quote here or you can simply apply for a short-term rental loan here. Or, if you need to reach them by phone you can call 1(855) 848-2862.