Recently the Ten-year treasury note was at 0.60%. This is important, because many debt rates peg themselves to this index…especially in the commercial real estate world. This is because, the Treasury rates are seen as the safest investment return because the debt is backed by the guaranty of the US government. It is also viewed as a long-term debt benchmark. The financial markets will add a “risk factor” to this safe rate to determine the market price for home loans, development loans and other forms of real estate debt.
The spread is that “risk adjustment” that lenders put on the Ten-Year Treasury for a mortgage payment. For example, the banks we deal with may charge a 225-275 basis point spread to the T-Bill to come up with our loan rate. Last year, the spread of 250 basis points meant that we could get a loan at maybe 3.20%. Today, the Treasury is around 3.0%, and our borrowing rate is over 5.0%. A $1,000,000 loan was $32,000 per year in interest costs, but has now risen to $50,000 per year. This affects how much we can pay to buy or develop real estate. If it costs us more to buy/develop then consequently, our yield will go down OR the price of the asset we are buying needs to come down to offset our debt cost.
Simplistically, if your cost for a home loan went from 3.0% to 4.5%, you would have to pay $850 more per month for a $1 million loan. That means to qualify for the same loan last year, this year you will have to show $10,000 more income to qualify for the same loan. The average median income is over $90,000 in Atlanta, so you would have had to have over a 10% increase in your salary to afford the same loan.
Commercial Value Adjustments and Negative Amortization
The “cap rate” is the measure investors use to value real estate. In simple terms, it is the return for an asset with no leverage (debt). For example, if an investor wants a 5.0% return (cap rate) and the cash flow is $100,000 before debt, then the asset is valued at $2,000,000 ($100,000 divided by the 5.0% cap rate). If interest rates go up, so does a buyer’s expected return and the cap rate. So as interest rates increase, either the buyer’s return requirement has to go down (because more profits are going to higher debt payments) or the seller’s price has to come down. The cap rate adjustment lags the interest rates increases as sellers and buyer have standoff. Apartments today are selling at 4.5% cap rate; however, the long-term debt to buy these is around 5.5%. This creates negative amortization, meaning the cost of the debt is higher than the return on the investment. So how can this occur? It doesn’t.
1.) Buyer/Seller Disconnect – tell a seller the price they could have gotten 120 days ago is now ten percent less and he will stay in denial for some time. Assuredly, the buyer has real cost increases and isn’t likely to offer as much as they could have 120 days before.
2.) Pricing Adjustments – in the commercial world, a Seller’s price will need to be adjusted or buyers will need to accept less returns.
3.) Housing Demand - will soften – not because of demand but fewer people qualifying for loans to buy a house.
4.) Demand for Apartments/Rental Units will be strong – mainly because of point #3.
5.Push across the board – landlords will be trying to push rents even more to help off set debt costs from increases in rates.
In summary, treasury rate increases impacts real estate pricing. In the increasing interest rate environment, borrowers are paying higher monthly mortgage rates, which is reducing net cash flow. In turn, investors are demanding higher returns to adjust for the higher cost of capital. As costs increase, landlords usually pass along the higher monthly cost to their tenants in the form of higher rent, in hopes the tenants can afford the increase.