2018 Market Update: Interest Rates, Cap Rates, Inflation & Predictions

Latest from SMK - There has been much uncertainty and volatility in the market and we are pleased to shed some light on the latest economic and real estate trends.

A few top level recent trends of significance include:

• Unemployment has fallen from a 26 year high to a 16-year low of 3.9%
• Meanwhile labor force participation (those eligible to work) has been hovering near a dismal 63%, close to its lowest level since the 1970’s
• Inflation is causing everything in general to be more expensive
• Stock market volatility is becoming the norm

Our country and the overall economy is now in uncharted territory, and what is in store for us in the near future is difficult to determine.

In the paragraphs below we will take a closer look at the trend in interest rates, cap rates, inflation and our underlying affordability concerns. We’ll also review market predictions now that the U.S. economy is in the 2nd longest expansion on record.

Let’s dive in.

Interest Rates

The Federal Reserve controls the rate that banks borrow from each other in short term transactions. This influences other interest rates including credit card rates, adjustable rate-mortgages and home-equity credit lines to name a few.

The Fed recently announced its plans to continue to increase interest rates. Rates have increased twice since January and 2 more rate hikes are expected by end of year.

The chart below outlines the trailing 12 month U.S. 30 year fixed rate mortgage rate, which has increased 90 basis points in the past 9 months.

Most understand that a higher borrowing cost reduces home affordability, making it harder for families to make ends meet, but let’s review in more detail how rising interest rates affect commercial real estate investments.

The valuation of commercial real estate is primarily determined by the cash flow that the asset creates. Assuming all other things equal, when interest rates rise, the future levered cash flow of a property decreases and thus the value of the property as well. Although interest rates are expected to continue to increase, this does not mean one should not invest in real estate. During a rising interest rate environment the correlated risk of declining asset valuation can be mitigated.

Knowing where we are in the cycle and projecting future interest rate increases is essential in conservative underwriting. In today’s market, our investment analysis assumes that the future sale price of an asset will be based on a higher capitalization rate (cap rate) than what it is being traded at today.

We expect future buyers to demand a higher rate of return to offset the increased borrowing cost associated with higher interest rates, and building this into initial projections is essential for success.

Cap Rates

As many have experienced, it has become increasingly difficult to locate investment properties that yield high risk adjusted returns. The chart below outlines the trend of cap rates across several U.S. commercial real estate asset classes.

Apartment cap rates (in blue) have been steadily declining since 2010 and this trend will eventually level off, or reverse course and begin increasing, just as it did from 2005 to 2010.

You’ll note that apartment cap rates increased about 1-1.5% during the last downturn from 2005-2010. We suggest planning and underwriting for a similar upward trend in the years ahead, a topic we recently discussed and provided examples in How To Identify Conservative vs Aggressive Real Estate Financial Projections.

Inflation

Consumer inflation in the past 12 months hit a more than 6-year high which can be seen in the chart below. This trend essentially means that the cost of living in the U.S. is rising rapidly. Most recently, the rise in costs have been felt at the gas pump, in medical care and housing among others.

Although these 3 essential living costs are on the rise, unfortunately inflation-adjusted wages have remained virtually unchanged. The chart below from the Economic Policy Institute outlines the lack of wage growth during our recent recovery, where median income earners are largely feeling this income stagnation.

Affordability is the main concern we face in today's marketplace. Income growth has been nearly flat while the cost of living continues to rise. If this trend is not reversed, it will be one of the major influencing factors to result in a market correction.

Inflation is not all bad however. During periods of inflation, real property values increase and as noted above, rising housing costs and rental rates result in real estate valuation increases. This correlation results in income generating real estate to be a good hedge against inflation as the increase in income generated can keep pace with the general rise in prices across the economy.

In addition to increasing costs of living, many businesses are struggling from the affects of inflation. A local home builder here in Oregon recently shared with me a few trends affecting his business. Labor and material costs have increased faster than the resale price of the homes, and his margins have been squeezed to the point where building homes is no longer profitable. He is on the brink of making the difficult decision to stop building homes, as today’s environment is no longer affordable for his business to continue. Although this is only one example, it does provide a telling story of our current market place and the affordability issues we are facing.

Market Predictions

We are currently in the 2nd-longest economic expansion in U.S. history, and will set a record if the trend lasts about 1 more year. This stat alone makes many leery of what lies ahead.

Half of the respondents to a National Association of Business Economics survey feel that a recession is likely in late 2019 to mid-2020 which is when the government’s $1.8 trillion stimulus starts to fade. The survey was conducted from May 9 - May 16, 2018 and the respondents comprise of a panel of 45 professional economic forecasters. What is also important to note about the May survey is that there has been a growing number of panelists forecasting a recession:

“The panel has shifted its sentiment regarding the risks to the outlook since the previous survey, with more than half of survey respondents—57%—currently indicating that the balance of risks to real GDP growth through 2019 is weighted to the downside. This is in stark contrast to results in the March 2018 survey, which reflected over 75% of the panel stating risks were largely weighted to the upside for 2018."

Half of the panel expects the next recession will occur sometime between the fourth quarter of 2019 (Q4 2019) and Q2 2020. One-third suggests a later time frame after the fourth quarter of 2020.

Bill Gates recently participated in a Reddit Q&A, “Ask Me Anything” and stated that a recession is inevitable. When the Microsoft co-founder was asked, “Do you think in the near future, we will have another financial crisis similar to the one in 2008?” Mr Gates responded: “Yes. It is hard to say when but this is a certainty.” Mr Gates said his friend, Berkshire Hathaway founder Warren Buffett, had “talked about this and he understands this area far better than I do”.

In Summary

Affordability is a big concern in today’s market and it is important for investors to proceed cautiously. As we continue to towards the longest economic expansion on record, now is not the time for speculative investments.

Although we are in an environment of rising interest rates, inflation coupled with stagnant wages, and the high likelihood of a recession, we are bullish on the future of carefully chosen cash flowing real estate investments. Nobody has a crystal ball, timing the next recession is impossible, but a correction can be mitigated against and at SMK we strongly believe in planning and underwriting for a market correction when selecting an investment opportunity.

To your success!