Cheap Money is the Opium of the Masses

Blake asked about the prudence of buying rental property in the current economic environment.

Thanks for the question Blake.

 There are many kinds of recreational drugs. Some begin destroying your body in obvious ways immediately (think crack or meth), others take a while and then might kill you suddenly (like the stroke you might someday have from smoking opium).
The advantage to the drugs that show horrible and obvious signs of damage immediately is that it give the user pause for thought regarding their current "recreational" activities. Conversely, the drugs that start killing you in unseen ways might give you the impression that they are not hurting you at all, making you feel safe to continue taking them.

North America have been on a 20 year drug binge, but the drug of choice has been the "few side effects, followed by a stroke" kind.

After the dotcom crash in 2001, western governments reduced interest rates many times in order to "stimulate"* the economy.

• *Economists who follow "Keynesian" (named after a British economist named John Maynard Keynes) economics believe that governments should "stimulate" their economies by lowering the rent people pay when they borrow money (AKA interest rates) and spending more (so more money is flowing through the economy) when times are tough, and raising interest rates and spending less when times are good. This policy works well in theory, but what often happens (and what happened over the last 20 years) is that governments will reduce interest rates and spend more when the economy is slow, but when it speeds up, they don't raise rates or cut spending (since these actions are not popular with the voters), which results in an "overheated" economy, inflation, over-investment,  and eventually a crash.

These declining interest rates made it possible for people to afford bigger and bigger houses with the same monthly payment. The result was an enormous increase in the amount of outstanding mortgage debt.

As people continued to buy houses, property values began to rise. As property values went up, people began to borrow more and more money to afford the bigger and bigger houses. Since the economy was humming along, unemployment was low, and economists were predicting the good times to last, consumers and investors felt comfortable taking bigger and bigger risks.

As people and companies borrowed more and more to build more and buy more, the business world responded by hiking production (which stimulated the economy even more). Demand was rising and supply was struggling to keep up. Homebuilders were building as fast as they could and they knew that all they had to do to make money was to build a house, so they built as many as they could, at higher and higher prices.

After a while the market hit a tipping point. Consumers who wanted houses and could afford them had bought them, but builders kept on building. Houses began to pile up. Houses began to sit on the market for longer and longer times.

Eventually, an awareness spread through the economy. The boom was over, house prices were not going to go up forever, and people who had bought multiple overpriced investment properties either became scared and dumped them onto the market at a loss, or held onto them until they could no longer afford the payments and lost them to the bank.

This rapid reduction in demand for houses at the same time as a rapid increase in the supply of houses on the market caused the prices to drop like a rock, and the economy went down with it.

Now, in a much different economic landscape, with asset prices dropping and unemployment rising, governments wanted to stimulate their economies, but alas, interest rates were already at very low levels and the government was already spending lots of money. The only options available were to drop rates even more and spend even more (ie, the bailouts of GM, Chrysler, the big financial firms, and "Quantitative Easing" #1 and #2)

So now, here we sit, with interest rates at record lows and governments spending money at record rates and trying to keep their economies as stimulated as they can.

But neither of these can continue forever.

Governments cannot spend forever, and they can't reduce rates any more than they already have.

When governments stop holding interest rates artificially low (either willingly or not) rates will climb... and they have lots of room to move.

Here is a chart showing mortgage rates for the last 60 years. (source Bank of Canada)

As you can see, where rates are now is lower than they have ever been. Eventually, rates will have to start heading back to more normal levels.

Over the last 60 years, the average mortgage rate has been around 8%. We are currently at about 4%.
If a person has a mortgage at 4% on a $300,000 house, they are paying $12,000 in interest per year or $1,000 per month. If Interest rates increase to 6%, then the interest payment would rise to $1,500 per month, and if rates revert to the historical average of 8%, the homeowner would be paying $2,000 per month in interest.

If you have a mortgage lock in for 5 years at 4%, and rates rise, your payment will not change initially, but when you go back to renegotiate your rate at the end of the 5 years, you would not be able to renew your loan at 4%. You would have to get a new mortgage at the rate available at the time.

Here is a suggestion: take your outstanding mortgage amount and look at your current rate. Could you afford to continue paying your monthly payments if rates went up to 8%?

Now here is another thought. When rates go up, and people began having to renew their mortgages at much higher rates, many homeowners will find their new payments unsustainable, and choose to sell their houses. This increase in the number of houses on the market will have the effect of reducing home prices.

Here is what I am predicting: Just as a reduction in the interest rates had the effect of increasing the affordability of houses, demand for houses and prices of houses, an increase in mortgage rates will have the opposite effect.... reduced affordability, reduced demand, and reduced prices.

So, Blake, buying revenue property could be a good idea, but I would suggest you get the property for a really good price and make sure that even if interest rates return to 8%, you could still make the payments.

If you can find a place that meets these criteria, you might be in a position to rent your houses out to the people who can no longer afford to live in their own.