On a phone conference a month or so ago, discussing an equity investment, the subject of future cap rates on real estate was a healthy part of the discussion. As it turned out, two of the parties on the call were old enough to remember April 1, 1982 when $6,000,000 in City of San Bernardino, California Industrial Development First Mortgage Revenue Bond (Riverview Industrial Buildings), Series 1982 were issued.
Interest rate – 14.75% DOUBLE TAX exempt
Maturity April 2007
Prime Rate (February 82) was 16.50% - down from a high of 21.50% on December 19, 1980 ---
The 10 Year Treasury was 13.71% on April 12, 1982 eleven days after the bonds sold
Real Estate Capitalization Rates? Who remembers? Research is hard to locate – but prudence says they had to be 500 basis points higher than 10-year treasuries – or more than 18%.
The Riverview Industrial Buildings had to project almost $1.2 million NOI to support the Bond Issue!
An 18% Capitalization Rate!
Will cap rates go that high again? In Zimbabwe or Venezuela you say – but never in the U.S! And we certainly are not forecasting rates that high.
The point is, that from 2001 to 2015 – a large part of many currently active real estate investment careers – cap rate spreads have averaged 403 basis points over the 10 year t-note, and varied from a low of 192 basis points to 509 basis points above the 10 year. The 10 year T Bill has been as low as 1.6% in that period.
If today's 3.2% 10 year rate moves 150 basis points, (or 200 bp as predicted by Jamey Dimon, CEO of Goldman Sachs) and cap rate spreads move to the median 403 basis points, the result is an 8.5 to 9.5 cap rate –
How many transactions, underwritten from 2009 to 2018 will lose value at a 9.0 cap rate?
Not that we’re forecasting that rate –
we simply don’t know – our opinion is no more certain than the eleven different opinions you can get by asking eleven different sources next week.
What do we know?
We do know how to protect your income and your capital when making new real estate equity investments in an increasing interest rate – and cap rate – environment. Investor Howard Marks of Oaktree Capital set forth some sage advice;
“For a value investor price has to be a starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price.”
The real estate economy seems to have seasons following the national and world economy, in much the same way the earth has seasons. Unfortunately, economic seasons don’t follow the calendar like the earth’s seasons. We endured a long economic winter, from 2009-2012, followed by a cool and not so fast-growing spring from 2013 to 2015 which turned into a summer economic season that seems to still be in progress – maybe turning to fall – which means a winter period is out there on the horizon somewhere. Fall is a time to harvest, protect the crops, prepare the seed for the next spring, sharpen the tools and make good plans for the next season.