Real Estate Investing – Is the Low Fruit Off the Tree?
Real Estate Investing – Is the Low Fruit Off the Tree?
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Special Edition
Real Estate Investing – Is the Low Fruit Off the Tree?
Higher Interest Rates - Toxic For Real Estate Investors
In our year ahead report, we outlined potential headwinds to the downtown Boston residential real estate market (see report here). At the top of our list was the prospect of higher interest rates, and we touched on the cost of credit as well as the potential negative impact on the wealth effect. In this report, we’re looking at how rising interest rates may impact real estate investors and the implications for values and liquidity.
Investor activity in our market is rampant, and for good reason. Boston is a premier world class city with a fundamentally strong economy. For many years, the downtown Boston market was supply constrained. Couple that with ultra low interest rates and a banking system overflowing with liquidity and you’re off to the races.
The lack of supply narrative is changing pretty dramatically (see our report “The Great Boston Building Boom”). This is leaving many new developments struggling to find buyers, which is when investors tend to step in. Add to the mix the prospect of higher interest rates and we could be in for a bumpy ride.
Two Types of Investors – Traditional and Developers
There are two basic kinds of real estate investors. The first group is made up of traditional real estate investors with long term investment horizons. They assemble portfolios of properties and generate profits through leasing. It’s a spread business.
The other group are developers. They run the gamut from small local firms rehabbing condominium units or buildings, to large national developers who tend to take on large scale projects. Their investment strategy is pretty straight forward - buy low and sell high.
Traditional Real Estate Investors & Rising Interest Rates
Traditional real estate investing is much like investing in a bond. With both investments you have cash flows backed up by an underlying asset. Bond investors express their expected return as the “yield to maturity,” and real estate investors have a capitalization rate (cap rate). The cap rate is simply the rate of return the investment is expected to generate. It’s the net operating income that the property generates (revenue (rents) less expenses) as a percent of the market value.
As the Federal Reserve pushed short term interest rates to nearly zero in recent years, yields on most income generating assets, including real estate, followed along with lower and lower yields. Just as with a bond, there is an inverse relationship between the cap rate and the value of the underlying real estate.
We’re constantly getting pitched investment opportunities with cap rates in the 2.5 – 3% range. Last week, we got the pitch on an “attractive” investment opportunity - a one bedroom condominium on the Waterfront offered at $700,000 with a cap rate of 2.2%. This implies the property generates net operating income of $15,204 a year.
We did a little math to get a sense of what would happen to the property value if the cap rate moved up just one point, from 2.2% to 3.2%. A one point move up in the cap rate, assuming the same operating income, drops the implied value of the property to $475,000, a $225,000 (32%) decline.
Investors aren’t getting compensated for taking risk
The idea of buying property with low single digit cap rates in a zero interest rate environment has never made any sense to us. Where’s your upside?
While the Federal Reserve has yet to actually raise rates, the financial markets are a few steps ahead. The rate on a 5-year Treasury currently stands at 1.63%, up from .45% a year ago. So in our Waterfront investment example, the investor’s 2.2% cap rate is only .57% over the return on a 5-year Government note. Keep in mind that the Government bond investor isn’t taking any credit risk and has instant liquidity; the same can’t be said for the real estate investor.
To be sure, unlike a bond where the coupon is fixed, real estate investors can increase rents. In periods of inflation, rents do typically go up, but these increases are usually driven by landlords passing along their higher cost to their tenants as opposed to gouging tenants.
Investors need to wake up and start pushing back on ridiculously low returns. Where we come from, investors get compensated to take risk.
Real Estate Developers & Rising Interest Rates
Developers are more or less the day traders of the real estate investment world - they get in and out as quickly as possible. Unlike day trading, getting in and out of a real estate development is measured in years. When developers break ground on new projects, they’re making forward looking bets on the future health of the economy. If mortgage rates double in the course of the development, selling the units would prove challenging.
If everything goes exactly to plan, a typical Back Bay brownstone condominium conversion will take at least two years from the time the developer takes title to the property to the time they can deliver finished condominium units. Larger scale projects take considerably longer.
The recent multi-decade decline in interest rates has taken a lot of risk out of the development business model, but that appears to be changing. Goldman Sachs summed it up well in a recent market commentary, “to be sure: the Federal Reserve needs to get the inflation tiger back in the cage; the Fed is no longer principally concerned with underwriting your portfolios of risk assets.”
The $3,000+/- per square foot new development pricing we routinely see is courtesy of developers bidding up the price of derelict properties to renovate (this is text book inflation, too many dollars chasing too few buildings). With dirt cheap mortgages and the wealth effect in full swing, many consumers have been willing to look the other way with respect to valuation.
If the Fed is effective at slowing down the economy and the music stops, we suspect that there won’t be enough chairs for all the developers. In the mean time, developers seem to be saturating the market with $10 million apartments. We often ask the question in our weekly market commentary, what will the market appetite be for these properties ten years down the road when the new car smell is long gone and we’re in a more normalized interest rate environment?
Summary
Our clients don’t calculate their projected return on capital when they buy a property to live in, but they are concerned about relative value. No one wants people whispering “they paid X for that place? What were they thinking?” Valuation matters, and investor activity has a meaningful impact on the supply/demand balance, liquidity, and overall valuation, so attention needs to be paid.
We’re the first to acknowledge that our baseline outlook for higher interest rates may not fully play out but the risks are clearly to the downside. As an independent broker with an emphasis on advisory over “sales,” it is our job to make sure our clients enter into transactions with their eyes wide open and our opinions and market views are an important part of the advisory process.
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About Batterymarch Group LLC – Batterymarch Group is an independent full service real estate brokerage and advisory firm focused on the downtown Boston high-end residential market. We represent both sellers and buyers with a sharp focus on valuation. We also offer sub-advisory and owner’s representation services to financial institutions, family offices, and trustees.
About Andrew Haigney – A 25 year Wall Street veteran, Andrew held senior positions at leading global investment banking institutions where he routinely valued and negotiated complex securities transactions on behalf of institutional clients. Andrew has been an outspoken advocate of a universal fiduciary standard. In founding Batterymarch Group, Andrew brings that same discipline and passion to the real estate brokerage.