Private property issue #4 - predicting interest rates

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Many investors are worried about interest rates going up. But how high will they go?

Here’s a simple trick to figure out what the 1-year rate is likely to be.

Every 6 weeks, our central bank – The Reserve Bank of New Zealand – has the chance to fiddle with the official cash rate (OCR).

This is an interest rate that directly relates to the mortgage rates you pay to the banks.

But what most people don’t know is that you can use the OCR to get a sense of what interest rates “should” be …

See how the two move hand-in-hand? If the OCR goes up, the 1-year rate goes up.

On average, the difference between the two has been 2.5% over the last 15 years.

Put simply, if the OCR is 1%, you’d expect the 1-year interest rate to be about 3.5% (+ or - half a percent).

That’s where we are sitting now, with 1-year interest rates sitting between 3.79% – 3.99% depending on which lender you talk to.

What does that mean for future interest rates?

The Reserve Bank has said that the ‘neutral’ OCR is 2%.

That means that if they're not responding to an economic event, that's what the OCR would likely be.

So the long term 1-year rate is likely to be around 4.5%. Maybe a little higher, maybe a little lower.

While these are higher than we have today, it’s important to remember these are historically very, very low. Just look how the 2 year rate has fallen over time 👇

So as interest rates rise, what can you do to respond? Here are four ways –

1) Buy more yield properties

Some properties grow in value faster but earn less rent (growth properties). Things like houses and townhouses in good locations.

Others don’t grow in value quickly but earn a better rental return (yield properties). These are properties like room-by-room rentals and dual-key apartments.

Over the last couple of years, cheap interest rates have encouraged investors to focus on growth. And it’s paid off.

But, as interest rates rise, some investors will add more yield properties to their portfolios.

2) Increase rents

The rental market is booming. According to the TradeMe rental index, rents in Auckland are up 5.6% compared to last year, and rents are up 8.2% everywhere outside Auckland.

To be clear, I’m not suggesting that you squeeze out as much money as you can from your tenants.

But, if you face higher costs through rising interest rates, that could be the prompt you need to bring the rent up to the current market rate.

Here is where rents have increased fastest over the last 12 months, according to TradeMe.

3. Decide how long you fix for

If you think that rates are going to increase quickly, you can lock your interest rate in for longer.

This tends to mean paying higher interest rates overall but means that your payments are consistent, and you won’t need to worry as much about interest rate movements.

Or, if you’re like me and think the 1-year interest rate tends to be lower and you’re happy to ride out the ups and downs. You might decide to only fix it for a year.

You need to be realistic about the costs you’ll likely face in the future. To see what this means for you, download our Return-on-Investment spreadsheet (for free).

This creates a 15-year cash flow forecast, and you can play around with what you expect the interest rates to be in the future.

When the property partners at Opes create these forecasts for the investors we work with, we are currently assuming 5% interest rates from 2025 onwards.

Download the spreadsheet for free here.

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