Permanently Low Interest Rates

[Derek Petersen]

Has anyone thought about what a permanently low interest rate environment looks like? Which strategies will dominate? For example, my end game has always been to hold real estate and ultimately carry back after rates go back to 7-8%. Maybe that never happens. Also, will cap rates continue to compress? Maybe we need to study Japanese real estate trends to get a glimpse of where we are heading?

Thoughts?

[Jonathan Twombly]

@Derek Petersen  While I think it's wise to game this out, I would not make any plans based on permanently low interest rates and cap rates, since that's a sure fire way to get burned.  It's best to assume that interest rates and cap rates will go up, based on the Fed's determination to raise interest rates to more normal levels.

But even assuming that they stay low, I think there will still be property cycles in real estate, given the following: (1) DSCR requirements. Right now, deals are falling out because they cannot meet the debt service requirements of the banks and still meet the return requirements of investors. So that puts an upper limit on prices and will cause some players to exit the market and wait for better times. (2) Limits on rent growth. It's already reported to be stalling and perhaps even falling in some markets. If investors cannot underwrite large rent increases to justify "overpaying" for property, then many will pull back from the markets. (3) Even small increases in interest rates, combined with what's going on above, could cause the bubble to burst, if it pushes returns just a smidgeon too low. (4) Exhaustion - at some point, investors feel they are overweighted to real estate and pull back.

I think there are some differences with Japan.  (Full disclosure:  I lived there for 4 years, travel there every year and speak the language fluently, and I have Japanese investors in some of my deals.)  Japan is suffering from population decline, which is accelerating.  However, it is also experiencing population growth in Tokyo and to a lesser extent Osaka, because people continue to move to the cities and the countryside is becoming depopulated.  Furthermore, like the US, Japan has outsourced many of its best-paying jobs to China, so wages have fallen - something that, for some reason, is rarely discussed in connection with the population decline.  Despite low interest rates for decades, my understanding is that cap rates are still reasonably high because investors are anxious about population decline.  Also, the market there is very different than here because there really is no rehab/repositioning business.  Buildings are built to a 30 year standard (recently raised to 50 years) and when they are finished with their useful life, they are torn down and replaced.  All the value is in the land, and very little value is in the buildings.  So, where there is still land pressure, like downtown Tokyo, property values are high, but in rural areas, local governments are literally giving away land to anyone who will agree to move there.

As long as we have strong immigration to the US, we will be okay, since that is where almost all of our population growth comes from.  If the immigration spigot is turned off, then we might have to worry.