Interest rates have been behaving against the trend for the past two years, but cap rates haven’t been following suit, which is a signal that change could be coming in our industry, according to Adam Deermount, managing director at Newport Beach, California–based Landmark Capital Advisors. Deermount wrote the following article for SoCal Real Estate about trends in interest rates, what he sees in the recent pattern, and what could transpire economically in the near future.
The Great Compression
by Adam Deermount
“You can’t predict. You can prepare.” – Howard Marks
Perhaps it’s difficult to remember now, but there was a period between early 2010 and late 2016 when interest rates moved predictably in a downward direction — especially on the long end of the yield curve — every time potentially destabilizing geopolitical or economic event occurred. It didn’t matter whether the news appeared to be positive or negative; rates generally seemed to move in only one direction as there was a notable deflationary bias and the so-called “flight to safety” trade was very much intact.
Then, the 2016 presidential election happened, and its surprising result was met with a Treasury sell-off and a corresponding increase in yields — exactly the opposite of what surprise geopolitical and financial events had generated over the preceding six years. In the aftermath of the election, I wrote the following:
“As I write this, longer-term bonds have sold off substantially, leading to higher interest rates, and swap spreads have widened. It seems to me that markets are anticipating that Trump will spend a lot on infrastructure and tax cuts and finance both with debt — all of which is being viewed as inflationary.
“Combine this with the fact that we are already seeing wage growth tick up of late, and you have a recipe for rising inflation. Again, I have no clue whether this trend will hold (if I had the ability to forecast interest rates accurately, I’d be on a yacht somewhere rather than writing this blog), and it could reverse at any point due to either economic, policy, or geopolitical circumstances. The important thing to me is that the market reacted differently to potential instability and turbulence than it has at any point in the past six years, and that response in and of itself is an important signal that change could be afoot.
“At the moment, the movement in rates is still relatively small, and short-term rates have barely budged. However, this is a development that has to be monitored closely as interest rates are such a key factor in the cost of real estate capital and by extension valuation. The so-called ‘flight to safety’ trade into U.S. Treasuries may have hit an inflection point this week. If that is indeed the case, we need to hope that long-awaited robust real economic growth will accompany any further increase in borrowing costs, but only time will tell. When it comes to the cost of capital moving forward, things just got interesting.”
The day that post was written, the 10-year Treasury was yielding around 2.3 percent, and it was in the high 1.7 percent range just a week before that. Today (Friday, October 5), it sits at 3.23 percent, the highest level since 2011 and well beyond the level that billionaire investor Jeff Gundlach has identified as a “game changer” with regards to inflation expectations.
At the same time, the 30-day LIBOR was yielding just below 0.6 percent, compared with 2.27 percent today. In percentage terms, these moves are massive and have driven up the cost of debt substantially, even as spreads have tightened somewhat.
What’s most notable in this market, though, is that unleveraged yields on commercial real estate (cap rates) have barely budged — and in some cases have even fallen, while rates have steadily marched higher.
Ultimately, there are two parts of the real estate cycle. In the growth phase, the spread between debt yields (borrowing costs) and equity returns widens. In the contraction phase, it compresses. Stable cap rates and increased interest rates have resulted in a compression where debt yields are rising while equity returns are actually falling. As such, we now find ourselves very solidly in the contractionary part of the cycle. We are also at a point where traditional fixed-rate debt with 25- to 30-year amortization tables is no longer accretive to cash flow.
For example, a 4.98 percent interest rate (10-Year Treasury + 175) has a loan constant of 6.43 percent (the loan constant takes the portion of the payment that goes towards amortization into account as well as the interest payment). However, good luck trying to find a well-located, leased property that yields much above 5.5 percent on a stabilized basis in this environment in top-performing markets. If you borrow at 6.43 percent on an investment that yields 5.5 percent, you have a problem. By way of example, that same spread would have resulted in a constant of only 5.34 percent on a loan with a rate locked in the final weekend of October 2016 — a full 100 basis points lower.
Lenders have largely accommodated this negative movement in rates by allowing for ever-longer interest only periods in exchange for steadily lower leverage — effectively pre-amortizing a loan. However, the lower leverage requires more equity and, as such, lowers the returns on that equity even further. This can only continue for so long until borrowers and their equity partners cry “Uncle!” and demand a higher return on their capital for the risk that they are taking vs. those in junior and senior lien positions.
In looking at the paragraph above, one would assume that commercial real estate values are at the point where Wile E. Coyote has run past the end of the cliff and is about to glance downward to his doom. However, most everything about this cycle has required throwing the economic textbook out the window, and today’s market dynamics are no exception. The fact that cap rates have remained constant during this period of rising rates is a tribute to the incredible influence that supply has on market pricing.
In a “normal” cycle, cheap capital boosts affordability and investment returns and pulls demand forward, resulting in substantially more speculative construction. Then, when that demand is exhausted and/or the cost of capital increases, absorption slows, and the resulting weight of excess supply of units causes prices to fall. With the notable exception of class-A multifamily and condo units in some markets (Hello, New York City and Miami!), that didn’t really happen in this cycle.
Instead, the cost of debt capital has been increasing substantially at a time when inventory is still incredibly low by historical standards. This means that a building on the market may receive less offers than it would have a couple of years ago, but that there is still enough “must place” capital that invests regardless of price (think exchange buyers, foreigners looking to get money offshore and some pension/life company investors) to keep values elevated and cap rates suppressed.
Eventually equity investors are going to tap out when the spread between debt yields and equity returns gets too low for them to stomach. However, it’s difficult to say when that will occur. Thus far, lenders have maintained a remarkable level of discipline in keeping advance rates low on loans with extended interest-only (I/O) periods. If they start offering longer-term I/O on higher advance rates, you can be sure that the end is near. Otherwise, I suspect that things can continue on like this for longer than most would believe possible even in an environment where the 10-year Treasury is now breaking through to the upside and the Fed is determined to continue hiking on the short end of the curve.
That being said, debt yields and equity returns cannot compress forever. The breaking point will be reached at some point, and it’s better to prepare for that than to bury our collective heads in the proverbial sand.