Rate Free Risk

It is generally regarded that short-term government bonds define what the risk-free rate is. In fact as the wags point out, what we have right now is rate free risk.

As I have been pointing out, the risk of increasing interest rates is a lot higher than is commonly understood. As the following chart points out, it is not just that interest rates are low. It is not just that interest rates are very low. Interest rates are as low as they have ever been in history.



A simple road map to successful investment. What is not well understood by the average person is the effect of rising interest rates on investment values. Let’s say that the rate of return on an investment in real estate is 5%, maybe the storage units that Eddie mentioned in the comments recently. If the risk-free rate goes from the current 1% to 3% then the rate of return demanded by potential buyers on your storage units will go up. That means that the price has to go down. Let’s say the new rate of return is 7%. Assuming your rents and your vacancy rates stay the same, that means a decline in market value of almost 30% in what you can get if you decide to sell your property. If your down payment was 20%, well ...

This does not necessarily mean you should not buy. But if you do you need a fixed rate over the full term of your commercial loan so you can hold the property until your loan is paid off. Or you need to pay cash for your rental storage units. If you purchase a REIT, a real estate investment trust, you need to make sure the REIT has no debt or has a good fixed rate of interest on any loan it might have.

Remember that rising interest rates reduce the value of all investments, including stocks.

I do not think I am going out on a limb by saying that interest rates will go up. My guess is that interest rates will drop some more before they rise. It will be a bumpy ride. Prepare as best you can.