Navigating Through Rising Rates And Capital Market Fears

Dated: 02/05/2018

Views: 531

With a stronger than expected jobs report this past Friday where 200k non-farm payroll positions were added to the economy last month, and more importantly even the forever stagnant wage growth reading rose .3 % (albeit right in line with expectations), the "good news" was enough to push the 10 year benchmark yield to a 4 year high of 2.84% at the time. This glowing progress report for the economy was actually the catalyst for a 665 point drop in the DJIA , followed by a drop of 1,175 points on Monday. Now, you might ask what this has to do with the real estate market, and the simple answer is everything. Nothing kills price momentum in risk assets quite like the fear of quickly rising interest rates, especially when that price momentum has been built upon a foundation of cheap money. 

If the past couple weeks have been any indication, where the bond market continues pushing yields higher, and if central banks decide they want to get to that party early and stay late to make sure "inflation" is behaving , then it's going to potentially have a very significant impact on the current real estate market. What does that mean for most? Well, just like anything in life pain for some and great opportunity for others. 

The following details some thoughts on how and why: 

There is a large pool of investors out there that have had up-sized returns over the past 8 years who literally only know one market direction - and that’s up. In that type of environment where a rising tide raises all ships, it becomes easy to pull out capital and keep levering up, but the bigger danger there is that it also rewards you for modeling your financial risk assumptions down to practically nothing. Anyone that’s had a multi-family offering memorandum placed in their hands over the past few years and glanced over at the pro-forma column know exactly what I'm talking about here, and make no doubt about it, there are plenty of deals and loans out there written based on or near such rosy assumptions. The danger there is in the event that rent growth levels out (and how it's somehow extended this far is a story in and of itself), or God forbid even falls slightly, and you place that atop an investment environment with higher interest rate re-sets and tougher financing, that can become pretty shaky ground for some. None of this even takes into account the spread between bond yields and the premium return you get for having to deal with leaky toilets and bad tenants, being squeezed to nothing or even potentially inverted on some deals in place. 

Now are things about to blow-up overnight? No, the Fed is much too cognizant of what their monetary policy has done to risk asset prices to do anything reckless (at least one hopes anyway). Can rates rise at a much more accelerated pace than what the market had anticipated, and in doing so weaken prices in risk assets like equities and real estate? Absolutely, especially if fear finds its way back into the markets like it recently has and continues to spook investors into a sell-off. Furthermore, having been a fixed income trader for nearly 15 years, there are some fundamental issues with the bond market which can cause some turmoil as well, the major one being fear of a liquidity crisis in the event everyone starts to look to the exit all at once. An argument can be made however that an equity sell off could push investors into the "safety" of bonds, therefore lowering rates, but I ask how safe can that be when your locking yourself in at a lower yield in a potentially rising rate environment orchestrated by central banks? That’s another story for another time, but the takeaway I'm aiming for here is that there lies the possibility for some volatile yield spikes along the way too. 

So some suggestions I feel are prudent to be cognizant of as a real estate investor: 

Rehabbers - follow mortgage rates closely and move even faster and more nimbly in and out of deals than you already do. Remember the rough estimate that a 1% rise in mortgage rates can potentially make a purchase for a buyer 9% more expensive on average. Not to mention the physiological effects if the stock market continues to fall and takes 401K account values right down with it. On a side note, there are theoretically actions one can take to hedge this risk when entering a flip that creates a somewhat more market neutral investment, but that’s a complicated discussion I’d be happy to go over with clients. Another variable in the equation is the new Tax Cuts and Jobs Act voted through, and its corresponding ramifications on SALT. This new legislation can have a potentially dampening effect on home prices also, yet it is still too early to make any strong assumptions there. My personal belief is the new tax legislation will become more of an issue for homes in the $11k - $18k tax range. However, supply still remains fairly limited, especially in train towns that tend to have higher tax rates, so that should at the very least provide some stability and a floor. 

Multi-family Investors - adjust risk assumptions accordingly on current investments and if things seem too tight consider exiting out while you can, not when you have to. With the nature of deals taking sometimes up to a fiscal quarter or longer to close, comps can become a stale and outdated guide to market sentiment if things become volatile. All of this is moot if you’re holding long term and can ride out volatile market fluctuations and a weakening economy though, and kudos to you for placing yourself in a situation to do just that. Regardless of where you stand though, having a strong balance sheet can set you up for some potentially significant opportunities when we eventually do hit the next downward cycle and price re-set. Lastly, for those still looking to accumulate units, as I have stated time and time again, seeking out value-add plays as opposed to turnkey opportunities is crucial right now. 

Please feel free to reach out and discuss some of the topics I’ve touched upon here or regarding any other pertinent issues you'd like some feedback on, I’m always happy to help. And if you’d like any property valuations done that’s something I’m always willing to help with. As always thanks for reading!

Best,

Bill

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William Sonzogni

Bill comes from a Financial Services background having spent 15 years on Wall Street, where he built and managed an institutional fixed income trading desk that catered to some of the largest hedge fu....

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