I wonder if future rate increases would decrease multi-unit price?
Since multi-units are priced based on CAP rates, they will be interest rate sensitive. Ie buying a multi-unit at 10% CAP makes sense in a 3% treasury-rate environment, but what if treasury goes to 8% in the future? I assume the CAP rate of the multi-units would need to increase to keep up. So unless rent jumps to, does that mean the price of the multi-units would need to decrease?
Let's say an apartment complex costs 100K and generates 10K in cash flow, assumes now market demands 15% CAP rate, and a rent increase of 20%. Even with now 12K cash flow, the unit is worth now 80K and a drop in price of 20%? So would it be wise to wait to buy multi-units? Especially given the market for them seems pretty hot? Any intelligent and analytical response would be much appreciated!
@John Tran,
The answer is, "It depends". In markets where the median home price / median household income is very high, a higher interest rates will have much more of impact in housing prices compared to where the ratio is very low (lower than 3), thus the housing in the area will be less impacted. Also in terms of valuation of real estate, I look at rental parity: If it is cheaper to own than to rent : the asset is under valued whereas if it is cheaper to rent than to own : the asset is over valued.
What is much more important than the interest rate is the purchase price as you always can refinance in the future at a better rate, but cannot change the price you paid for your asset. Some of the smartest economists and hedge fund managers I know have been calling a reversal in the ten year yield for several years now. Bill Gross made a big announcement in the finanical media that it is the end of the 30+ year bond market rally couple of years ago. The 20 year treasury has rallied 27% since Jan 1st, 2014 until today.
For those of you who think it is impossible for rates to go any lower, the Japanese and European 10 year bond is less than 1% where we are currently at 2% today.
The markets can stay irrational for some time, but fundamentals will always win out in the long run from my experience. Right now is a time I find the financial markets to be extremely irrational.
What you are saying is one thesis. As interest rates rise (if & when), cap rates increase, decreasing value. Borrowing rates will also be higher, decreasing income.
The other thesis is that interest rates are going up because the Fed feels more comfortable with the economy improving, which generally leads to increased rents, which offset the impact on price. (i.e., income goes up, so the higher cap rate can produce the same or even higher price).
The other impact is that if investors expect MF prices to go up as the economy improves, higher appreciation expectations cause decreases in cap rates (because investors are counting on additional returns beyond this year's cash flow).
@Account Closed and I have discussed this. After our conversation, I did look up and find an academic paper that generally found no consistent correlation between interest rates and cap rates. I think a lot of it depends on the "animal spirits" of the market and how much leverage is available ;)
So if Treasuries are at 8% in your scenario, the question is, why? Because the RE market is going up so quickly, the Fed is trying to cool it down? Inflation is accelerating? (usually w/ increased rents). It can definitely cause prices to go down too, but it's not a foregone conclusion, and difficult to predict, IMHO - especially the market's reaction to what's going on.
@John Tan you should be more concerned about inflation. Your property may be worth more in dollars numerically but be of less value in an absolute sense when inflation is factored in.
Of late, T-Bills and CD's tend to have interest rates below the real rate of inflation. Don't worry about those. Do be prepared to re-adjust your rents as tenant's leases expire. Remember: if your investments are not gaining more than the real rare of inflation you're losing money.
@Minh Le and I have discussed this. After our conversation, I did look up and find an academic paper that generally found no consistent correlation between interest rates and cap rates.
Do you have a link to that paper? I love to read more about that...
Just from a common sense standpoint, you have to wonder how that could be the case. Hedge funds are typically looking for 6-6.5% returns (cap rates when buying MF) these days. Assuming treasury rates at 6%, why would a fund choose 6% cap rate property over getting 6% in treasuries? All the extra risk and work just for some potential appreciation?
The other thing to keep in mind is that cap rates are only reflective of unleveraged purchases. When interest rates rise above 6%, it will be impossible to get positive leverage on a 6-cap property (there are more nuances than that, but that's the gist). At that point, demand drops significantly, causing prices to drop (and cap rates to increase).
Again, just the common sense viewpoint, which -- in economics -- is very often wrong. So, it's quite possible I'm wrong... :-)
@J Scott I think about this logically the same way as you, however, I hear time and time again from MF investors far more experienced than me that this lack of correlation is true. They've told me that rates go up because the country is seeing growth. This growth leads to higher incomes and essentially higher rents. So while rates are going up, so are NOIs so people are wiling to pay more for the income stream.
Again, it doesn't make logical sense to me. But this is what I've heard. I'll see if I have any actual data I can share.
http://www.morganstanley.com/assets/pdfs/articles/FrozenontheRates.pdf
@J Scott I think about this logically the same way as you, however, I hear time and time again from MF investors far more experienced than me that this lack of correlation is true. They've told me that rates go up because the country is seeing growth. This growth leads to higher incomes and essentially higher rents. So while rates are going up, so are NOIs so people are wiling to pay more for the income stream.
Again, it doesn't make logical sense to me. But this is what I've heard. I'll see if I have any actual data I can share.
Doesn't make sense to me that rents can keep pace, but again, there are lots of things that are true in economics that I can't get my brain around...I guess I can add this to the list... :-)
Thanks all for your responses.
I agree the consensus is it depends on how much rent increases (wage driven) vs market demand for CAP rate. However, without historical numbers, it will be hard argue one way or another.
In my original post, I had a hypothetical change of 20% wage/rent, and treasury rate going from 3 to 8. I think 3 to 6% is more realistic associated with a 20% wage/rent increase. So redoing the numbers:
10% CAP at 3% treasury (7% premium for multiunit)
13% CAP at 6% treasury (same 7% premium), and 20% rent increase. 100K unit at 10%, would be worth 92K at 13%, so a drop still. I think numbers for SFHs generally give the same results, i.e. under typical scenarios, wage growth won't be able to keep up with rate change in residential (what Bruce Norris believes as well). So affordability goes down and a net negative effect on SFHs.
But I'll try to get some charts together. It is easy to find interest rates, harder to find historical wage changes. anybody has a good chart already on rent vs interest rate going back at least 30 years?
@Account Closed Le and I have discussed this. After our conversation, I did look up and find an academic paper that generally found no consistent correlation between interest rates and cap rates.
Do you have a link to that paper? I love to read more about that...
*** The main reason this analysis identifies is that cap rate spreads over treasuries compress as interest rates rise. Interestingly, cap rate spreads (this index for large transactions) were about 450 bp over 10yr treasuries in the last two troughs, and only about a 50 bp spread at the peak in 2007. That implies a 400bp "absorption" of the interest rates that didn't impact the cap rate in the last cycle. (See pg 3). They also analyzes a longer period of upward rate movements and you can see the cap rate often compressed during increasing interest rates. (pg 4) Nevertheless, they state some of the rate increases will pass through..
http://www.cbre.com/AssetLibrary/Interest_Rates_an...
Just from a common sense standpoint, you have to wonder how that could be the case. Hedge funds are typically looking for 6-6.5% returns (cap rates when buying MF) these days. Assuming treasury rates at 6%, why would a fund choose 6% cap rate property over getting 6% in treasuries? All the extra risk and work just for some potential appreciation?
*** Some would respond that for the expected rent increases that tend to occur, and even price increases as the Fed is raising rates (like last upturn, because the charts are going from the bottom left, to the top right), and being able to leverage those returns, yes, they have been shown to take that risk. See above also..
***Also, remember that there are not just hedge fund buyers out there buying large MF. The market is made up of a lot of players of varying sophistication (RE hedge funds probably at the top of that stack). Many have lots of money to deploy, including REIT's, Pension Funds and Sovereign investment vehicles from around the world, UNHW family offices, etc.. They want diversification, RE, and are in it through more than just a cycle..
***I'm not saying one or the other will happen. Just that it's not as consistent as I use to think either.. Conversations with Minh really did have me doing more research.
Nobody has the complete answer, but here are some historical numbers.... See below for treasury rates, and wage change (orange in chart below). Given wage and inflation are pretty closely tied together and Fed is targeting 2% inflation, we should see rate increases if wage gains go above 5%. So basically I don't see wage growth has that much free room to run without triggering jump in rates, which will generate a higher CAP rate demand/lower price. If I see large wage gains above 5%, I might run for the hills.... Then buy stuff with much higher rates at a later time.
@John Tran,
The answer is, "It depends". In markets where the median home price / median household income is very high, a higher interest rates will have much more of impact in housing prices compared to where the ratio is very low (lower than 3), thus the housing in the area will be less impacted. Also in terms of valuation of real estate, I look at rental parity: If it is cheaper to own than to rent : the asset is under valued whereas if it is cheaper to rent than to own : the asset is over valued.
What is much more important than the interest rate is the purchase price as you always can refinance in the future at a better rate, but cannot change the price you paid for your asset. Some of the smartest economists and hedge fund managers I know have been calling a reversal in the ten year yield for several years now. Bill Gross made a big announcement in the finanical media that it is the end of the 30+ year bond market rally couple of years ago. The 20 year treasury has rallied 27% since Jan 1st, 2014 until today.
For those of you who think it is impossible for rates to go any lower, the Japanese and European 10 year bond is less than 1% where we are currently at 2% today.
The markets can stay irrational for some time, but fundamentals will always win out in the long run from my experience. Right now is a time I find the financial markets to be extremely irrational.
@ J Martin, thanks for the thoughtful response. Two followup questions:
1. so you think amount of optimism in 2007 that caused the spread to shrink will return this time around?
2. in general, I think it is best to buy from the dumb money and go with the smart money. (so in sequence of smarts as: mom and pop MF investors, hedge funds, mom and pop real estate investors, investors from other fields, mom and pop passive investors) Do you see smart money leaving or slowing? I think I see relatively late money looking to jumping in, so I am leery.... i.e., I see MF eventually going down, how early in cycle are we?
Great info...I appreciate it!
thanks a lot @ J Scott, great link. Only 200 basis points in spread between treasury and cap rate, that is pretty low! Looks like lots of deals are still out there by that standard.
Not my link...@J. Martin gets credit for that one!
not gonna happen any time soon. People aren't underwriting to caps in the way you think. Today, people are underwriting to the delta arbitrage of interest and cap. It's all macro, and big forces are in play to keep it that way. Most think it'll be 3-5 years before this breaks.
We've been talking about it in this thread - lots of good stuff here!
J,
There's a myth out there that interest rates will rise. I am sorry, but they have been saying the same crap since 2009. I know the pundits will eventually be correct. :0)
Give me a reason why you believe interest rates will rise. During the recent mortgage meltdown, residential mortgages got slaughtered due to ninja loans. Commercial mortgages held up much better, do you know why? If the Great Recession didn't take down the commercial market, what do you think a typical recession would do? My guess is not much, and there is a very solid reason behind it.
Running analysis on a spreadsheet is cool and all, but the reality is a little different. I used to think I could buy apartment buildings at a steep discount at the courthouse steps. Unfortunately, very little went to sale/auction between 2009 and 2013 when I was out there, with the exception of 4plexes which were residential mortgages. Knowing what I know now, I understand why that was the case.
Looking at the cap rate vs. 10-year treasury rate, the gap is reported at 440 bps, which is much closer to the bottom than the top of the market. People like @Ben Leybovich would be saying....WHAT? It's apparent at this point that the gap has a higher probability of getting narrower/compressed going forward, but who knows. There is no reason to stop accumulating when the deals still meet your underwriting investment guidelines. It's time to consider taking some chips off the table when nothing meets your underwriting guidelines.
By the way, there has never been a 700 bps spread between cap rate and 10-year treasury so your analysis has to be more realistic. Otherwise, it would be garbage in, garbage out.
@Gene Hacker is very good friend, who has a thorough understanding of economics. Gene is an economic genius IMO. Forget Robert Shiller, Nouriel Roubini, Robert Pretcher, Harry Dent etc. If I need economic advice, I ask Gene. :0)
Gene's Deflation, Inflation and Stagflation Thesis, which started in February 2009, has been debated until NOW. We agree with each other practically all the times so there's not much debating between him and I. Basically, if Gene says jump, I say how high. Hope to see you in the next 2-4 weeks bud. Anything you want to add to this thread?
Thanks for the kind words Minh. I agree with you that rates will not be rising significantly any time soon.
The central banks of the world have been taking turns printing new funds to keep the party going. Japan announced a huge round of QE (ie: money printing) this past fall, and the ECB might be stepping up next.
Its very easy and popular to lower rates, and print money. From politicians to wall street to Realtors...everyone likes cheap (or free) money. But removing liquidity and rising rates is not met with the same enthusiasm. The markets will react strongly if/when the fed starts increasing rates. Most likely...the fed will talk about it a lot. They hope just talk will cool the markets sufficiently.
If inflation actually takes hold then I feel that our fed will be forced to start rising rates, but they will likely be chasing inflation, not getting in front of it.
And even if inflation gets a bit overheated, I don't think the fed will be as aggressive as it would need to be. Yellen is no Volcker.
And what if the market has a decent correction...I think there is a good chance the fed would use it to push through another round of QE. QE helped make the banks a ton of money.
Rising rates will not necessarily lead to a drop in RE prices. On the contrary, the idea that rates could rise TOMORROW and make buying more difficult, can lead to an impression of scarcity and drive up demand (and prices) TODAY. This happened during the 80s bubble
Thoughts?
@Minh, Gene, and Dmitri:
Good points.... You are right, there is actually a positive correlation between residential prices and interest rates. Ie, when rates rise, prices actually rise and not fall (go back 100 years, that is the case). So there is not too much fear on my part for the SF residential side. Funny I have been arguing this since 2011, when everybody said don't buy because rates will rise and price fall..... Japan this and Japan that.... And I argued for FED being behind the curve and always slow to act and there won't be deflation. Then I get my own arguments brought up at BP :).
But in the long run (I'm investing for 5-15 years), I think everybody agrees rates have to rise to more historical norms. When everybody said rates will rise in 2012, it never did. Now everybody says it will stay the same, I bet it will rise...
So think I wiser to stick to 4-plex and lock a 30-year rate instead of floating with a commercial loan .
Talking about regular multi units (2-4) not complexes, smaller or relative rate changes won't impact prices in the plains states in good markets anyway.
Well all of you are getting into pretty sharp detail about all this and honestly I'm struggling with a couple things.
1) I didn't see any end to a post that dictated anything with clarity in terms of making a purchase decision so it all seemed rather academic in nature, which is great but even with 2 degrees, about 10 minutes of that required a break from the material.
2) The discussion seemed to chase a lot of "what if" scenarios with expectations that current trends in recovering markets would be linear in that the heat will keep coming and something has to keep rising, either rents, price, rates etc.
So, I may have a very different vantage point being here in the middle of the country, nearly all the posts were from either east or west coasts. When speaking about complexes anywhere in the country cap rates and all the other metrics will be used as a valuation I'm sure but the real world has boundaries and that's why I got the impression that there was a lot of academia in the conversation.
PRICES on MFH can only rise so much before it becomes unattractive to purchase - that is a real life boundary that will end this discussion.
RENTS - can only increase so much to keep pace before a property is unattractive and vacancy rates increase and rental rates become a detriment to the investment because there is a limit to which rents can rise in a given market (sustainability or lack thereof).
AND RATES - rates can only get so high before the rate level slows the economy and then later slows the economy to a degree that significant damage to the economy occurs. Obviously the fed would seek to mitigate such effects on the economy with respect to rates and rate changes but with respect to buying as an actual investment rather than speculative purchases (as we saw in pre-crash behavior and property prices) and knowing you were going to be making money at the time of purchase and that the return would be acceptable to the investor(s), there is a window in which property values must fall before they exit out of view to one side or another (law of diminishing returns) and after values have left the investment window it really doesn't matter how high or low rate or values rise or fall, we as investors will not be discussing the matter anyway. We will have moved on to other areas or property types that will yield returns.
Anyway, I might get run off of this post for my lack of ability to discuss cap rates at length and so on and so forth, hopefully not. And if I am off in left field by myself, would somebody kindly give me a direction to travel to be able to discuss these cap rate matters as if we were talking about the weather.
Thanks - Jeff
Over the long term meaning 40+ years and on a large scale such as whole country, yes those factors do tend to equalize. But it's the wild swings in between that will have a much larger impact on your investments over a time period that is relevant to you as an individual. In between is where we get the bubbles and the busts.
Cap rates CAN fall to silly low unsustainable levels - look at Hong Kong and Singapore with 2-3%
Rents CAN rise to silly high levels
Interest rates CAN jump to double digits (if this ever happens again, I'm buying 30 year treasuries...)
But as you rightly said, most of this is academic. The real answer is having a finger on the pulse of your own specific market. You can make money in any market, but you must know what market you are in. There is no substitute to actually knowing.
not gonna happen any time soon. People aren't underwriting to caps in the way you think. Today, people are underwriting to the delta arbitrage of interest and cap. It's all macro, and big forces are in play to keep it that way. Most think it'll be 3-5 years before this breaks.
It was interesting to see from the Treasury chart that there isn't really a typical treasury yield. The post-World War II low interest rates lasted for 15 years.
I think what will drive long-term rates higher will be inflation. Generally wage growth will drive inflation - which will also increase rents and housing prices. So I think overall the forces will offset each other.
This recovery does seem to be a bit backwards in that generally wage growth will drive asset(real estate and stock market) values, partially due to inflation and partially due to demand.
Interesting information.
I do think that jobs and wage growth are still coming in this recovery. The funny thing about the economic cycles is how we perceive them. We usually don't realize how good things are going until it is past us.
I agree with those that feel that inflation will drive real estate prices and rents upwards.
Cap rates are an elusive number. What is reported and stands out there as the official numbers are often skewed. Cap rates are too easily manipulated and regularly misreported. When some article comes out and states that the average cap rates are 7%, my first instinct is that they are actually at 5.6-6%. There is no agency out there checking to see that brokers are accurately reporting the caps at sale. I have frequently seen them be misreported on large buildings that I have evaluated.
The number that I have heard tossed out as the spread is 2% or 200 basis points. Meaning that the investor is typically looking for a cap rate that is 2% higher than the interest rate.
The discussion of wages influencing rents is absolutely fascinating to me. It has an important impact on rents. It's very concerning to me, also -- because real wages have been declining since the 1970s.
Rents are essentially a function of wages and inflation. Normally, we'd assume that inflation can be disregarded because all prices will increase at the same rate. I think this relationship is becoming unhinged as the wealthiest are taking the lion's share of profits from Fed-driven inflation and government spending, with wage-earners and tenants enjoying a tiny and declining portion of the new economic activity.
This poses a dilemma for the real estate industry. What happens when inflation drives up all prices except wages? Tenants get squeezed, and real rents have to fall. Either it drives cap rates down or it drives real asset prices down.
And although I understand that a rise in interest rates will compress the spread, there still is a positive, if trailing, correlation between cap rates and interest rates. A 6% cap building is not selling in an environment with a 10% risk-free rate.