Why Interest Rates Matter
My real estate colleagues and I are glued to the 10-year US Treasury (UST) rate. We all want to know where it’s headed and how long it will stay there. At no point in the past 20 years can I recall spending so much time wondering about where this interest rate will go. The typical non-real estate investor sees higher interest rates and knows it makes homes and autos more expensive to finance. As a result, you can purchase less with the same monthly payment. Alternatively, higher interest rates produce an opportunity to park cash in a tax advantaged US Treasury or money market account earning 5% or more. Those with a particularly adept wealth manager might even purchase other debt instruments paying much more than 5%. Just like with real estate investing, there’s both opportunity and pain because of the rate environment.
In normal economic times, rising interest rates are a sign of prosperity. For example, the 10-year rose from a low of 1.5% in Q1 2016 to 3.05% in Q2 2018. The real estate market did not break after this 155 basis point move. Instead of obtaining acquisition financing around 3% for new apartment purchases, we had to borrow just over 4%. Values did not fall since economic growth was positive, and there remained ample value-add apartment investment opportunities. This move in interest rates took over two years, was methodical, and felt predictable to those of us in the market. As a result, it was easily absorbed.
More recently, the move in the 10-year UST from 0.66% at Q2 2020 to 4.59% as of Q3 2023 was significantly faster and steeper. During 2021, the 100 basis point increase in the 10-year didn’t impede values at all since most owners experienced rent growth of 20-30%, leading to significant increases in net operating income and valuations. Nobody minds increasing interest rates when income grows. However, the leg from 1.52% in Q4 2021 to 4.59% as of Q3 2023 has been especially steep and has been met with stalling rents and rising expenses (particularly in insurance costs), resulting in lower income. It also happens to be poor timing for owners with floating rate loans who need to purchase new interest rate caps or have a maturing loan. In short, we are not in normal economic times.
Interest rates matter because they impact property values. Rates also impact capitalization (i.e., debt vs. equity amounts) and cash flow. Real estate is frequently a leveraged investment, meaning debt is used to finance the purchase. When debt is used, it can make a good investment great, and it can also turn a good investment bad. Even when debt is not used, the bond market presents an alternative investment and investors usually need more yield from real estate to offset the additional perceived risk. Interest rates permeate our business. Nobody focused on them for the past 10 years, pre-Covid, because the average yield on the 10-year UST was 2.4%. All real estate looks attractive when rates are that low. Now that they’re at a more normal level in the mid-4% range (the average from 2000 to the Great Financial Crisis was 4.5%), the market needs to adjust. The problem is that it hasn’t fully adjusted yet.
Recency bias is causing investors to hold on and seek alternative ways of financing to rescue their now troubled investment. The mantra “survive until ‘25” is apt because many owners hope interest rates will fall soon so that they can either 1) refinance their asset without a significant cash infusion, or 2) sell their asset at a more palatable valuation. The rise in the 10-year to 5.0% throws cold water on that mantra, but the subsequent drop down to 4.4% has investors hoping it becomes true. A recent Wall Street Journal article suggests the same.
Our curiosity with interest rates has more to do with the opportunity that comes from those feeling distress. In a time of uncertain values, cash flow can be a beacon of certainty, and cash yields are as high as they’ve been in almost a decade. However, with moves in the 10-year both up and down 0.5% in the span of weeks, it’s hard to assess value. Especially because real estate takes time to transact. It might be 60 days before you close on a purchase and that feels like a lifetime with today’s fluctuating rates. While 0.5% may not seem like much, it can move the price 10% in each direction, change loan amounts, and impact the projected yield. These are factors we generally like to have under control when making an investment for any of Calvera’s funds. We’ll keep watching rates so that you don’t have to.
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