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Alright number geeks, join me for a moment. The ten-year treasury has gone from 0.60% to a little over 4.0% in a very short time period, due to the Federal Reserve's attempt to control inflation. This has put all investment markets in turmoil but especially real estate investments. Let us explain the predictable results.
WHAT DETERMINES VALUE?
Any investment is valued by the market based on the safe rate of return increased by the riskiness of the investment. In the real estate investment world, a common benchmark for the safe rate of return is the ten-year treasury rate, which is backed by the full weight of the US government. If the federal government is paying 1.0% for ten-year treasuries, then a real estate investment would need to pay at least 1.0% plus the risk margin. The corresponding risk (as determined by the market) is the margin needed above the safe rate to compensate for that risk. The addition of this risk premium to the safe rate is called the capitalization rate or “Cap Rate” for short. This is the return needed in the first year of the investment.
So, for example, the investment market really liked multifamily, as rents have room to grow. The corresponding return requirements are low. People need housing, there is not enough of it and the supply is far behind the demand. Class A apartments, earlier this year, were trading as low as a 3.5% cap rate (3.5% return on investment). This would indicate a 250-basis point premium over the safe rate of 1.0% for T-bills. This would suggest that for an income of $100,000 in year one, that an investor would pay $2.857 million dollars ($100,000/3.5%) for the asset. Now let us play that forward.
Treasuries are now around 4.0%. Add the risk premium of 2.50% and you have a cap rate of 6.5%. There is a concept of cap rate compression, which is an indication of a narrowing in the risk premium as a compromise to high interest rates. So, for the same $100,000 income, the price an investor would pay for this asset would be $1.538 million ($100,000/6.5%). This represents a 46% drop in value!!
EXCEPTIONS
As discussed above, now that ten-year treasury interest rates are higher apartment values have decreased. We have heard several market brokers indicate decreases of 15-20% in the last few months. However, there is an exception. Some buyers are willing to take more risk and accept a smaller return and reduce their risk margin from say 2.50% to 2.0%. This is known as cap rate compression (lowering of the risk premium). History has shown that there is not a “one for one” correlation of cap rates and interest rates, which indicates a narrowing of the risk margins as the rents go up. In the multifamily sector, this risk gap is even narrower, because the potential for rent increases above historical levels. Simply put, you can increase rents to get your investment returns up in near term future years, so you will take a little more risk now (pay a higher price knowing your return will be better after the rent increases in years 2-5.)
MARKET DISCONNECT & THE FUTURE
There are several sellers who do not want to recognize a devaluation of what their asset was worth 12 months ago. There are buyers who could have a safe treasury rate earning 4.0% for ten years for no risk, which is what they would have accepted 12 months ago for a riskier real estate asset. So, the buyer wants more return for the risk. This will create a disconnect in pricing between sellers and buyers over the next 12-18 months while the Federal Reserve tries to get inflation under control. What to do in the meantime? Buy treasuries and sit tight!!
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