Mind the Fundamentals
[The Registry March 2011 Issue]
Vince Lombardi, the legendary Green Bay Packers coach, began every summer training camp by saying to veterans and rookies alike: “This is a football!” Lombardi was big on training fundamentals, and you can't get much more fundamental than peering at the pigskin. Commercial real estate practitioners often get caught up analyzing the leveraged, after-tax internal rate of return, comparing CAM charges per square foot, or dissecting the demographics of a neighborhood and the credit-worthiness of any particular tenant. While this analysis is important, it is easy to forget that fundamentally real estate acts like a corporate bond—if interest rates go up, values goes down.
Imagine Lombardi in a board room full of top real estate executives holding up an architect's model of an office building saying: “Gentleman, this is a bond. Now get in your three-point stance and give me ten 40-yard sprints!” Kind of like recess during grade school—only with a higher risk of heart attacks! The counterpoint, of course, is: “That is not true! Value-add expertise dramatically increases occupancy and net operating income.”
Successful value-added repositioning of real estate does indeed dramatically increase income, but even these projects will attain a stabilized occupancy and be subject to interest-rate risk. The trick with value-added projects is to sell them at the apex of the increasing income curve and move on to the next project. However, this business model is more akin to development than pure investing, so we are back to the characteristics of a bond, where rates go up, and values go down.
All of us who have been in commercial real estate more than a decade can vividly remember the havoc high interest rates wrought on the ability to transact deals. We all also remember that the historical average of the 10-year Treasury for the last 30 years is 7.11 percent and 6.82 percent since 1962. In the last 20 years the average has been 5.45 percent—pretty darn cheap. But sooner or later this metric will revert to the mean, and we are likely to find ourselves ecstatic having the 10-year Treasury being a touch under 6 percent.
Additionally, the historic spread between cap rates and the 10-year Treasury has been restored to slightly higher than 4 percent. The core commercial real estate market (trophy assets being the domain of cash-flush REITs) is having trouble getting deals done below an 8 percent cap rate, which makes sense. A 4 percent spread over a 3.5 percent Treasury translates into a capitalization rate of 7.5 percent. Add a pinch of safety to the spread to soothe the frayed nerves of real estate investors and voilà—a price ceiling tied to historic spreads. Perhaps the market has innate intelligence after all!
A banker friend of mine is convinced that the Federal Reserve will continue to do everything it can to drive long-term interest rates lower, and well the central bankers may. This does not mean, however, that the Fed can control the appetite of bondholders who will move their money faster than you can say the word “arbitrage.”
Bond traders are a lucky bunch; oceans of liquidity and mountains of transparent data upon which to make informed trade decisions. They don't care if interest rates in any sector or country are going up or down, only that they can get a jump on the market moves and ride the wave to the beach to paddle out for the next wave. If a bond trader sees a trend, he or she can place a bet with a few deft keystrokes, print the trade confirmation and go enjoy lunch. Real estate practitioners aren't so lucky. The time measurement between the decision to sell and actually getting a check is measured by geologists with carbon-dating technology. If an investor owns an acquisition acquired at an 8 percent capitalization rate, and interest rates begin to move up, the moment to make the sell decision has long passed.
Going long on commercial real estate by acquiring at today's capitalization rates is a bet that interest rates will stay flat and that the economy (or at least the rent roll of the asset) will grow. Few are predicting that interest rates will fall and even if rates fall, only incremental movements in the 20 basis-point to 30 basis-point range are realistic. This is a bet with only two outcomes. Status quo or worlds of woe!
Apologies in advance for being redundant, but stabilized income-producing commercial real estate is a bond. Buying properties today believing that the markets have returned to normal is a one-way ticket to disappointment. Whether you call this market distressed, turbulent, volatile or insane, the only way to hedge the risk of rising interest rates (other than a fully amortizing loan) is to acquire stabilized assets at a price that can insulate the investor from interest rates reverting to the historical average.
The arithmetic on this calculation is worth a mention. Should interest rates rise to their historic average and cap rates follow and settle into their historic average of 9.5 percent, an owner with a property acquired at an 8 percent capitalization rate would experience a 15 percent decrease in value should the market re-price the property at 9.5 percent capitalization rate.
This decrease in value can, of course, be offset by an increase in income, but it’s not a symmetrical increase. Holding vacancy and operating expense percentages constant means that gross potential income must grow 19 percent to support growth of effective income to offset the drop in value of 15 percent. Does anyone believe in this market that rents can grow roughly 20 percent in the next three to five years? If you do, then this level of rent growth will offset the potential decline in asset value and bring you even with your acquisition value—an outcome likely to cause most investors to whimper with fatigue and yearn for cash.
If you don't believe this rate of rent growth is in the cards, you can be comforted by the fact that many other investors are sitting on the sidelines with you waiting for the bid-ask spread to narrow towards the bid, so that the significant risk of rising interest rates can be offset by a lower acquisition basis.
Coach Lombardi was a huge proponent of teamwork. “Individual commitment to a group effort—that is what makes a team work, a company work, a society work, a civilization work,” he said. Is the Federal Reserve on the same team with commercial real estate practitioners? The answer, for the moment, is probably ‘yes,’ because low interest rates are causing commercial property prices to reflate, which helps banks rebuild their balance sheets. As soon as this task is accomplished, however, expect star quarterback Teddy “10-Year” T-Bill to become eligible to become a free agent and to seek what all free agents seek: the highest price. In this case, that is the cost of interest to service Teddy’s lavish lifestyle. It is as fundamental to monetary policy as blocking and tackling is to football.
