A Discussion on Interest Rates/Macro Fundamentals (Long OP)

Non-PC Broker's picture
Rank: King Kong | 1,348

While there was a recent thread about buying in a rising interest rate environment, I'd like to have a thoughtful discussion about where you're predicting interest rates to be in 1-2 years and how that will impact the market, if at all.

To preface the discussion: I first entered real estate shortly after the GFC and I suspect many of you did as well. Recently, I've had this nagging feeling that the market I've operated in over the past decade isn't "normal" and I should research the past 100 years (thanks, Ray Dalio). Sure, the pundits have been saying "historically low interest rates" for years, but I've just plowed forward as usual, accepting today's reality for what it is: reality.

Eventually the feeling arose that maybe I've been lulled into a "new normal" perception of the market since it's the only thing I've ever known. And what does "historically low interest rates" even mean from a contextual perspective?

Well, from 1995 to 2000, the Federal Funds Rate averaged somewhere between 5.4 - 5.5 %. During that same period, the Freddie Mac 30-year Fixed-Rate Mortgage Index averaged around 7.62% (ballparking). However, in 2001, things got wacky. Due to a recession and 9/11, the Fed Funds rate dropped to 1.75% in 2001 and 1.25% in 2002. Yet the Freddie Mac index averaged 6.97 and 6.54, respectively. Freddie Mac rates trended downwards for the next couple of years then stabilized in the high 5's to low-to-mid 6's before the GFC hit.

So, as you can see, even after a recession in 2001, rates never went as low as they are today. In fact, I had to go back to September 1, 1961 to find a Fed Funds rate under 2.00. We were sitting at 1.70 as of 5/1/2018, according to the St. Louis Federal Reserve.

As someone that's become active on the construction side of things, I've recently received written notifications from regional suppliers that there will be a substantial increase in the prices of goods across the board (think 5-10% minimum for almost everything involved in a stick-frame build). The notices didn't stop there as they stated we could expect another bump in November if things keep trending as they are now. There were a number of reasons for the increase but a unique one was the lack of labor to load the trucks and ship the materials.

Very low unemployment (3.8% and probably high 6's "real") combined with the aforementioned inflation makes my spidey-senses feel like things are going to be a lot different towards the end of 2019. I'm definitely not making the case for another GFC, but I am making the case that we need to be thoughtful about what the market could look like at that time.

Now to real assets: I recently bid on a value-add apartment deal in the sub $10MM range. I used completely reasonable assumptions that would normally have put me in contention 6-12 months ago. However, I'm 500k - $1MM off and there are tours for days on end... What's going on? Heck, I'm even using optimistic broker assumptions of where rents can go to in 2-3 years.

What are your thoughts on where this all leads to and what are your respective strategies for dealing with the uncertainty going forward? As a newly minted entrepreneur I'd like to be able to make things work, but every day things get weirder and weirder--and profit margins get smaller and smaller--as excessive liquid capital chases anything and everything. Yet, on the flip side, there's been at best equilibrium construction in most markets so oversupply isn't a big issue (assume case-by-base basis).

Within this context, I can't help but wonder where things are heading, what unique options are still available to the thoughtful investor, and what valuations could look like in 2-5 years.

Comments (63)

Jun 3, 2018

Interesting post--should draw some good conversation on here. I think it's important to consider how M2 has changed from the 2000s to now. Said plainly, the Fed has pumped 3x the money supply into the financial system since then and a lot of that money is going straight into equities. Europe did the same thing and a lot of that money went into UST's; these cross border flows have for a long time now suppressed our interest rates. Given where bond yields are at, real estate has been very attractive on a risk adjusted basis. Given the extreme valuations in the equities markets, I think investors are getting more and more skiddish and with interest rates going up, the rent bumps built into leases seems more appealing that locking in on a long term bond whose value will continue to decrease with rising rates.

I believe cap rates will remain low for the near term as investors focus on capital preservation over growth. Real estate seems safe relative to the stock market this late in the business cycle. If the Fed unwinds it's balance sheet at a gradual pace and doesn't shock the system, I think we may see slight lift to cap rates over the next 10 years but not a major correction like last time. There's too much money out there and it's got to be placed somewhere. We are seeing lenders (and LPs) taking a more cautious approach to investing in development projects and construction pricing make penciling deals very tough right now; we are in one of the top 3 growth metros in the country. If this is occurring elsewhere and new supply is held held in check, one would think this would keep rent growth positive and cap rates from shooting up.

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Jun 3, 2018

The supply of new construction and it's relation to future rent growth is an interesting topic. The issue we may run into, sooner rather than later, is that of wage growth not keeping up with rent growth. The combination of rent growth and healthcare inflation is going to continue to eat into the pockets of renters of class B and C apartments. There has to be a breaking point at some time in the future. Or let's just hope that real wage growth for the bottom half of the economy starts to pick up now that there's a shortage of labor in some sectors.

I do believe we have a looming housing crisis on our hands, which makes me bullish on apartment development in the right markets over the long-term (if you can tie up the land). I also play in the single family residential market and we are unquestionably under-built for first-time home-buyers. Yet there is no immediate solution in most metros as the cost of land + construction costs are too high to make the economics work.

Your comment got me thinking about one thing in particular that surfaced in my mind as a result of my research: we haven't been here before, or at least not in a very very long time. If true, this means our economic models are woefully unprepared to deal with "predicting the future" in any meaningful way.

While continuing to research after posting the OP I came across Howard Marks' most recent memo on the Oaktree website, in which he speaks to many of the issues I brought up in my OP--albeit in a much more eloquent and sophisticated manner. It's worth a read.

If I had to make a prediction, I'd put a decent probability on 6.5-7% interest rates in a couple years. I think it's highly unlikely that cap rates stay this low for 10 more years, but that's why there are winners and losers in markets, and I very well may be the loser.

On an asset level, this is what concerns me: take a model with 8 meaningful sensitivities (random number) and in an upswing with some decent growth and profit margins you can make things work if a couple of the sensitivities under-perform--you may even get general appreciation which alone exceeds your sale projections. However, what happens when things are "priced to perfection" (Zell) and you don't get that appreciation but your taxes go up 5-10% more on the reval and your rent growth stagnates for 3 years yet you're forced by your investors to sell?

In many cases, returns are so compressed that if you miss your 3% rent growth targets by 2% for 2 years on a 5 year hold, things change to "almost a waste of time" for the sponsor. The promote drops and the sponsors will wake up realizing they aren't making anything close to what they would have hoped for all the work and at some point a correction takes place. My models are so sensitive at this point that I'm crushed if a municipality has to increase taxes at a substantially higher rate than expected. Not "oh I won't make much money"...more like "oh, I would have made more by being in the S&P index".

Hopefully I don't sound like too much of a curmudgeon. I'm just genuinely confused at times.

EDIT: I realized I didn't address one of your core points that there's too much capital in the market. I agree with this and it seriously concerns me because it makes it so hard to compete. But at the same time I don't know what it means over the long term and how different macroeconomic scenarios can affect where that capital ends up over the next 5-10 years.

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Jun 3, 2018
Non-PC Broker:

I also play in the single family residential market and we are unquestionably under-built for first-time home-buyers. Yet there is no immediate solution in most metros as the cost of land + construction costs are too high to make the economics work.

To your point, I just licensed up in Virginia as a Class A contractor with a residential building construction specialty (something that was incredibly hard to do, btw) in an effort to build affordable starter homes in the Greater D.C. area. I've been trying to get the numbers to pencil out and I'm really struggling with it--this whole process has really demonstrated to me why square footage is king in single-family residential homebuilding. A huge portion of costs--land, HVAC systems, even roofing costs--either don't rise at all or don't rise in a linear fashion with the size of the house, but the price you can obtain does rise in a fairly linear (although imperfect) manner. In essence, most profit is derived from building big.

I'm trying to work out how to build a quality, inexpensive product rapidly for a reasonable profit ($~50,000 per unit--not a lot considering market risk + income taxes) but I'm running into an issue with cost. I just can't make it work. And the numbers keep telling me that apartments or condos are the only things that payoff if looking to build for affordability.

Jun 4, 2018

+1- fascinating thread

Jun 5, 2018

+1 - love that you mentioned Howard Marks because reading your OP he was the first thing to come to mind. His memos are fantastic and his book does a great job of outlining his thoughts on investing, cycles etc. Your whole post made me think of the phenomenon that he often discusses that investors often feel more comfortable taking risks as the market is rewarding them least to do so.

I'm not able to make any claims about where interest rates are going to be next week nonetheless in 2 years, but broadly it does feel like a good time to be mindful of the risks you're taking in a prospective investment. In the example you noted above, regardless of the time in the cycle, I don't want to be doing deals that don't work if any one of my eight key assumptions goes against me. Right now I am looking for deals where we can add some unique value (through development expertise, synergy with existing portfolio, etc.) - with a structure that isn't going to add excess risk through short-term capital/liquidity requirements, heavy interest rate exposure, etc.

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Jun 4, 2018

The fed or ebc can not suppress interest rates. If they did it would cause massive inflation and you would see high inflation with low real yields.

If they suppressed interest rates it's by putting too much money in the system which would lead to inflation.

Fed policy has actually boosted interest rates.

Array
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Jun 4, 2018

wrong ...just look at European govt interest rates....10yr italy, portugal, spain yields all significantly lower than 10yr US yields.....because the ECB bought them and pushed up their prices...and thus lowered their interest rates.

historically, central banks didn't buy long maturity debt...but after 2008 the rules changed...and that is the only reason why yields are as low as they are now.

just google it...you're welcome

Jun 3, 2018
traderlife:

The fed or ebc can not suppress interest rates. If they did it would cause massive inflation and you would see high inflation with low real yields.

If they suppressed interest rates it's by putting too much money in the system which would lead to inflation.

Fed policy has actually boosted interest rates.

I'm open-minded to this position because I've never really thought about it, but I've literally never read anyone--anywhere--who has argued that the Fed lowering their interest rate targets actually boosts interest rates. If that's the case, then it's news to everyone.

If what you're saying is that the Fed doesn't really control interest rates, then there's truth to that that most people would acknowledge, including the Fed, which is why they call it rate targets--ultimately, the market does set interest rates.

Jun 3, 2018

I think it's important to be humble and acknowledge the unknowable. It's as simple as Dalios economic machine model and then just testing the waters as you move in it. At this point in the cycle don't be too aggressive and acknowledge that this time isn't different it's just elongated due to the central bank activity

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Jun 4, 2018

Dalio & Howard Marks "The Most Important Thing Illuminated" are good reads right now!

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Jun 4, 2018

Dalio work only applies to a gold standard. It doesn't work anymore the way he describes things now.

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Jun 4, 2018

This is so far outside my paygrade / competency to address the question properly, but I did get a good nugget from one of our institutional LPs who had Yellen as a lunch speaker that I think is worth sharing here. She shared her belief that the 10 year UST will top out at 3.4% and that she is not seeing any real signs that would cause a recession. She thinks unemployment will tick down to low 3s and that when a recession comes, unemployment may tick up to mid 4s given structural considerations in the economy today.

Not endorsing that view, but an interesting and well informed opinion.

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Jun 3, 2018

I find Yellen's commentary interesting. On the one hand, she's an insider and may have the right information, but on the other hand she's out as a result of the new administration and their opinions may diverge. The 10yr is currently 2.90+ and they are projecting a minimum of 2 more rates increases this year plus another 2-3 next year. So, she must think something between now and then will happen to keep rates down. Maybe the ramp up in QE will have an effect?

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Jun 4, 2018

Totally agree, but I have no idea what is driving her beliefs. I guess my layman's view is that she knows a shit load more than me, and if I knew what the 10yr was going to do I wouldn't be doing this shit.

Jun 4, 2018

She thinks the rate hikes will cool off the economy and limit the need for more rate hikes.

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Jun 4, 2018

in mid-late 2007, lots of floating mortgages were set to reset from 0-1% teaser rates to then current rates of 5-7%+...which is what caused the financial crisis. Most of those people who had teaser rates were unable to afford the 5%+ payments....so the Fed had to get the 1yr rate back underneath 1% (which happened at the end of 2008...unfortunately it was too late...a conspiracy theorist could say that waited intentionally to create the environment for havoc...which allowed a small few to make billions). For the last 10 years, the same thing has happened...lots of teaser rate mortgages...credit quality deteriorating, etc...add inflation and enough time (probably a couple more years) and we can get another debt crisis.

In 2009, the fed's balance sheet expanded from under 1 trillion to 4 Trillion (ECB, BOE, BOJ, China have all done the same)...which is what kept long rates subdued for the past few years. With those QE programs rolling off...rates will naturally rise over time (slowly over the next 3-5 years)...and by then we'll probably have another debt crisis. This is why the 5yr treasry yield is now 2.78%, and the 10yr is 2.93% (so 15 basis points, which is very flat for 5 years of rate risk...and heading for inversion). Hard to time it exactly tho...but the market is expecting the next US debt crisis around the 2022-2024 time period. I would be out of real estate and renting by then and holding cash, and waiting to buy the dip.

just google it...you're welcome

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Jun 5, 2018
want2trade:

the market is expecting the next US debt crisis around the 2022-2024 time period.

Is this prediction just based on talking with colleagues? Or is there something in the yield curve suggesting this?

Jun 6, 2018

Closer to the OP - does anyone have an opinion on the San Diego RE market? Way too hot to even consider buying at this point? I was out there recently for a wedding and it made me wonder, is it even possible to play out there?

Jun 5, 2018

Definitely competitive; hot in various pockets. Lot of multifamily development coming online downtown (and really all over). Big difference from last cycle is much less single family development - largely due to lack of land. Not a ton of spec office development, but not sure that's far off. Qualcomm's contraction is a big story that could have a huge impact on Sorrento Mesa and surrounding submarkets. Can't speak much to industrial, but I think that it is up there with MF as SD's hottest sectors.

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