I don't understand how higher interest rates can work

[Helmut Forren]

I like to buy and hold single family homes for rental.  I have a strategy that has been working very well for me.  Of course, conventional financing is becoming increasingly difficult.  I've seen other financing methods, but the numbers don't seem to work for me. Yet, there must be a way to make them work, or they wouldn't be out there.  

I would greatly appreciate some well thought out advice to help expand my understanding from my current position to a position where this other financing might work.

To begin with, here's what I've been very successful at -- at least in my opinion.  I'm north of Atlanta Ga, and the numbers all work here.  I have spoken to my work associates near Washington DC, and my numbers do not work there.

I purchase a nice nearly move-in ready for something between $120K and $140K, sometimes a little less or more. I put down 20% or 25%. My mortgage PITI ends up between $700 and $800. Rent was $1100 but rates have gone up and they're all at least $1200. (The over $140K are 4BR and rent for more. The rest are 3BR.) This gives me roughly $400/month in rent above PITI. I earn a lot at my day job, so I pay my handyman to do all the maintenance. Because the properties are only 10 to 15 years old and were in nearly move-in ready condition, maintenance costs have been down below $500/year each. Overall, after depreciation protects most of the income, I have been earning about $4000/property after tax. I'm very happy with this.

For metro Atlanta suburbs, this rent level seems a sweet spot.  Qualified applicants are I believe upper middle class and tend to take care of the property and pay their rent on time.  This is in stark contrast to a quad I had in the past that rented for $700.  They also stay for many years.  For a new property or turnover, it only takes a week or two to get a well qualified new tenant who then turns out to be indeed good.

Regarding the $4000/property after tax, earlier purchased properties with $25K cost are returning 16% cash on cash, and if I include principle pay down, my ROI well exceeds 20%. Later purchased properties with $37K cost are still making 10% cash on cash with total ROI also approaching 20%. I definitely feel this is much better than I can get in the stock market, and these numbers tend to auto-adjust to inflation, which the stock market does not. Take the example in point of rents already rising from $1100 to $1200.

Within all of this, a very important factor is the interest rate.  I have interest rates varying from 5.125% to 4.75%.  The higher earlier rate was before property values/costs went up, and the lower later rate was after they started going up.  So all the properties wash out to roughly the same profitability.

Note that I don't want to purchase properties that require any rehab first, because all that does is increase my investment, decrease my leverage, and therefore decrease my cash-on-cash and ROI.

SO NOW I CONSIDER OTHER FINANCING.  But if the interest rate is 2% higher, and the mortgage is 75% of a $140K property, then my first year interest is $2100.  That's more than half of my $4000/year profit.  Maybe there's some funny math with carry-over losses due to depreciation exceeding returns, and later superior after-tax earnings if we assume inflation, but I just don't like the idea of my investment money suddenly only going half as far.

So, how can this other financing with higher interest rates work?  Are other folks happy with half the rate of return?  Or is there some aspect that I don't understand?  (Being leveraged, my risk level seems fine, having reserves elsewhere.  My mortgages are only 60% of my current rent, plus I have more than 6 months mortgage in reserve, so aside from the risk from deflation, I believe I'm pretty well protected.)

I could bring up the net per house by investing more, by either greater down payment or cheaper house with rehab.  But that simply dilutes my return as well.  And another thing, all my houses are in cookie cutter neighborhoods with all nice houses.  The stability is good for medium to long term.  Tenants are good.  Etc.  It wall works very nicely.  The rehab houses I've looked into are all in older neighborhoods with less certain near term stability.  And I believe on-going maintenance will be higher as well.

So, once again, what am I missing, if anything?

Thanks very much,
Helmut

[Kirk Olson]

I will elaborate on what @Steve Vaughan said with an example. I purchased a Duplex for $154,000 with a 2.75% interest rate. The taxes are ~4k a year so my overall PITI is $1147/mo and the total monthly rent is $1950. Now with rates hovering around 4.875% you would have to purchase the property around $120k to receive the same return. So if a buyer were looking for the same return their value of the property would be less than what it was when I bought it due to their cost of capital. The same holds true for owner occupant buyers. With a lower interest rate a family can afford a 230k house with a $1000/mo payment as interest rates rise that $1000/mo will pay for a cheaper house due to the extra interest.

There are ways to shield yourself from this a little.  The first being purchase value add properties.  If you intend to buy and hold you will have less money in the deal than a close to retail purchase and so your return will be higher, and if you intend to sell in the near term you won't have to worry about increasing interest rates eroding all your equity.

This is my first time through the real estate cycle as I've only been investing since 2012 but there are currently 3 exact same duplexes for sale near mine and I would not pay $154500 for them today.  I would still make money at that price but I can make more elsewhere. Hope this helped.