Not trying to be an economist but have been thinking about rates vs. RE for awhile now as the global economy seems to be quite stressed. Would love to hear thoughts on the below.
I recently read that 30% of global bonds are currently trading at negative interest rates, with Germany recently completing its first negative yielding bond issuance. It seems that with the US economy tetering on Trump's trade war tweets, and China potentially unwilling to compromise, we could be on the verge of our next 'correction' at which point Jerome Powell will have to decide on the course of action that could reinvigorate our economy. With the 10Y and 2Y currently at 1.5% each, we don't necessary have a lot of 'room' for further easing given it would only be a matter of time before we are also at 0 (or worse, negative like our European brethren).
If US real estate is seen as 'safe' globally, and foreign capital continues to flow into the US (lowering the yields on UST bills), would higher yielding US real estate assets not also experience a reduction in cap rates since RE typically trades at a spread to UST bills? In other words, if our interest rates continue on the downward trajectory they more or less have been on for the past 20 years, are cap rates likely to remain where they are today (or go lower) for the long term?
Cap rate would go lower if interest rate continues to decline
If rates decline, debt is cheaper, NOIs increase, rates decrease, yea
How would NOI increase if NOI has nothing to do with leverage? Is there an argument to be made that top line revenue growth could actually take a hit if wage growth turns negative or flat lines while expenses continue to grow?
If you have floating-rate debt, your debt payments decrease.
We saw 10yr money on MF at 3.25% a few years ago. It could easily hit 2.5% this time around. Caps go down unless a monster recession forces really high U/E.
U / E?
Unemployment?
At a certain point core multifamily cap-rates may be lower than UST bills due to perceived better credit risk... Frankly, I already don't see investment grade corporate bonds as carrying any higher risk profile than UST...
This would almost certainly require a downgrade on US Gov credit rating no?
Unemployment
Absolutely. Institutional core buyers typically target cash-on-cash returns and lever these acquisitions 50-60%. If interest rates decrease a higher asset price can be paid to achieve the same cash-on-cash return thus lowering cap-rates.
What worries me in the CRE market today is not the health of core and core+ assets but unobtainable aggressive value-add rent growth assumptions and the high leverage points on these deals. Workforce housing can't grow rents forever at 3-7% per year when real median wages are flat... Also, everyone assuming 3% operating expense growth and limited CapEx is going to be in for nasty surprises down the road when buying improvements built in the 80's and 90's...
This is exactly what I was saying but you numb nuts gave me monkey shit
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Cost of debt does not change NOI. NOI is a before debt service unlevered calculation...
Jumping off what InVinoVeritas said above, it really is about how people utilize this information in their assumptions. Real estate does not operate in a vacuum, it is the backdrop to life. Unless you live in the wilderness as a nomad traveling around and collecting fruits and hunting animals, you're involved in RE.
With that said, we are operating in a yield starved environment where lots of capital sources are chasing whichever deal they can find. We see oversees investors chasing 2% yields just to park money. We also see the flipside of that coin- the Gross Revenue of real estate, as largely stagnant (in most markets). Rent growths are slowing because income has not effectively risen, retail is getting crushed, residential home sales have fallen off a cliff, hospitality is stable (surprisingly) but we've seen this movie enough times to know it can fall at any correction (like that corporate debt imploding, meaning less business travel and less discretionary income for tourism), industrial is booming because of Amazon but that has limits (and may already show signs of those limits and overbuilding), and office seems to be super regional in performance.
Coming to a conclusion, with rates and yields being compressed so thin and nothing to bolster growth (and justify growth assumptions), I think something will give. Not sure what, how, why, or when. This pattern of low deal flow and stagnant wage and population growth seem unsustainable.
Edit: Going back to the topic at hand- I can see rates dropping until something in the machine breaks. Without getting overly political, I could definitely see this current administration repeating the history of Herbert Hoover and believing this is a natural course and to let it be. Could be from belief, could be from lack of options.
Agree with all your points about performance getting worse. My hunch is that there will be a massive divergence of true core cap-rates from everything else, especially high walk-score downtown multifamily and mixed-use built to last 100+ years often situated along public transit.
I just visited downtown Denver and stayed with my buddy right next to Union Station. I was so impressed with the planning of this area, the public/private cooperation, and the improvements quality of all the buildings (brick, steel, and cement). Previously I did not understand why investors were buying core assets at such low cap-rates but now I realize that there is a scarcity of properties you can buy to hold for 10+ years and know with surety that rent performance will grow and the improvements will actually appreciate in value due to increasing skilled construction labor scarcity and materials inflation.
Ostensibly, yes, US cap rates have ample room to compress and while we don't have a lot of "room" for more accommodative interest rates relative to history, the US is the best positioned for QE/ZIRP. As the rest of the world's central banks move in lockstep with the U.S, they've found themselves in uncharted territory ($15T in negative yielding bonds). Remember, the U.S is the "world's Central Bank" when you think about it...
Many of the global economies floating debt with negative interest rates have the lowest cap rates in the world.
In fact, the argument can be made that cap rates are still attractive in European and Asian markets on a comparative basis to the US.
In the case of Europe, depending on product type, cap rates may be ±400 bps above comparable bond offerings. In the U.S the spread can be as little as 250 bps.
In both Asia and Europe, industrial cap rates look especially attractive as they are typically above those in the US. I suspect this is due to e-commerce being less mature in many EU economies.
I guess my point is there is an asymmetric relationship between global/US cap rates and global/US interest rates. Case can be made the global RE markets are disjointed.
Unfortunately it's not that simple when we're talking about a confluence of global central banking policy and RE valuation fundamentals....
Agree with Malta Monkey & InVinoVeritas. Folks have often been aggressive in their projections, using on-par assumptions for RE assets from Tier 1 through to not so great assets.
Also agree with some posts above w.r.t. yields vs. corporate bonds vs. gov bonds. Many institutional FI desks look at these three buckets as their opportunity cost, so there is a degree of a relationship between them.
And 3, the most obvious point, lower rates means cheaper debt. Cheaper debt usually means prices rise because things are easier to afford.
Theoretically negative interest rates would make hard assets (real estate) and very high growth potential investments (tech unicorns) the places to go for yield. Traditional Warren Buffet style value investing doesn't work
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