Comprehension Question Regarding Interest Rates

[Aaron Webster]

My apologies for the simplicity of the question. Why exactly, does a rising interest rate diminish the appeal of owning real estate for the purpose of renting or flipping (for investors)? One can assume this is due to the increased cost of borrowing and subsequent decrease in return but is this not equally true for competing investments classes such as equities or bonds? Just trying to understand why investors shy away from real estate in a "rate rising" environment.

[Shafi Noss]

Nice question, here's one angle:

With real estate you pay an interest rate, but with bonds you receive an interest rate. You can see what a higher interest rate means for each of those. 

Some important additions to the picture:

(A) Inflation matters: Real estate tends to appreciate with inflation, while bonds don't. So even with higher rates, RE can be a better option. You have to consider all the profit sources that a bond or RE can provide.

(B) Cap rates matter: Suppose you want to buy a property for $1MM making making 80k (8%) a year cash on cash . But then rates go up and it's now 70k a year to handle the extra interest you're paying. That sounds bad. But are you now making 7% cash on cash? Maybe. If the market now says the asset is worth 700k, then you're actually making 10%, even though rates went up. How frequently this actually happens is another story but this dynamic is part of the picture. 

The numbers I used in the example are not exactly what cap rates are, but the effect is the same. Hope that's helpful.