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3 Strategies to Prepare for Rising Interest Rates

by Andrew C. MacDonald on February 9, 2011

Going Up

Over the past decade we have become accustom to low interest rates. After rates plummeted to “emergency” levels in 2007 following the global financial crisis, healthy cash flows were a nice perk as real estate investors made their way through our most recent recession. With rates still hovering below historical averages and our economic recovery gaining momentum here in Canada, it is inevitable that rates will begin to rise. While you can’t do much to stop rising interest rates, in today’s article I outline 3 strategies you can use to prepare.

Where Are Rates Headed?

Simple, rates are headed up. Why? Because economics said so.

For starters, jobs are growing and unemployment is on the decline. Real GDP is growing more each year, and forecasts for sustainable growth are now the consensus among leading economists. Combined with historically low interest rates this only leaves one possibility as we forget the days of “The Great Recession”.

To provide some perspective for today’s generation who can’t imagine double digit rates, here is a picture worth 1,000 words.

In their recent report titled “Canadian Home Resale Market Outlook”, RBC Economics estimates a further 1% increase in the prime rate during the remainder 2011 which will put us at 4.0%. Adding their forecast 1.5% increase in prime over the course of 2012 will put prime at 5.5% by the end of next year.

3 Strategies to Prepare for Rising Interest Rates

Understanding rates are going to rise, we want to be ready. Here are 3 strategies you can use to prepare.

1. Build Your Cash Reserves

Cash is king, and as long as you have enough of it to make your payments you can whether just about any financial storm. Use the excess cash flow you earn with today’s low rates to build your cash reserves. Having access to cash will help you cope with higher payments in the future and keep your options open.

2. Accelerate Payments

Another camp of investors suggests using the excess cash flow from our current low rate environment to accelerate your principal payments. The idea here is to save on interest and make sure payments are lower when you refinance at the end of your term. Just be sure to plan your cash needs to avoid putting yourself in a jam down the road. Also, check with your mortgage professional to see how much you can pre-pay to avoid triggering any costly penalties.

3. Adjust Your Projections

If you’re still in acquisition mode or working with Joint Venture partners, you’ll want to reexamine your projections to make sure they reflect rising rates. If you’re still running properties through your analyzer at a 2.5% interest rate, you’ll be disappointed down the road. Take a look at your current portfolio and any future purchases to make sure they’ll still fit your strategy at an interest rate of 5.5%. Update your assumptions when analyzing new deals, and be sure to manage expectations for cash flow or distributions with any Joint Venture partners in advance.

Further Reading

If you’re worried about the impact of rising rates, read my article Adding Perspective to Interest Rates to see how much every percentage increase in interest rate will impact your bottom line.

For some good insight into the future of our housing market, check out RBC Economics’ latest report entitled “Canadian home resale market outlook: moderation,moderation, moderation“. The first page offers a great summary if time is a constraint.

Creative Commons License photo credit: twicepix

Sources:
1. Statistics Canada, CANSIM, tables (for fee) 176-0025, 176-0043, 176-0047 and 176-0064; Bank of Canada, Bank of Canada Review, Ottawa. http://www40.statcan.gc.ca/l01/cst01/econ07-eng.htm

2. Statistics Canada, CANSIM, tables: 176-0043, 176-0064,176-0067 and 387-0006; Bank of Canada, Public Information Service (1-800-303-1282). http://www.statcan.gc.ca/pub/11-210-x/2008000/t098-eng.htm

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