How the value of your assets connects to the Fed Funds Rate and why your investment strategy matters.
Last week, we discussed the structure of the US Federal Reserve Bank and how the monetary policies it pursues impact the cost and flow of capital in fulfilling its mandate to promote healthy economic growth.
We likened the Fed’s actions to working the pedals on the floor of your car, where the gas pedal lowers interest rates to speed the economy up, and the brake raises interest rates to slow economic activity in response to the threat of unhealthy inflation levels.
In response to the so-called Great Recession, the Fed stomped on the gas pedal by lowering its benchmark rate to 0%. When that didn’t produce the desired effect, it started printing money electronically and buying back US Treasuries and Residential Mortgage-Backed Securities (RMBS) in a process called Quantitative Easing (QE).
School is still out on the results, but conditions were dire and the actions of the Fed were defensible. Doing nothing could have sent the country into another depression. We will never know, but we’ll take what we have over what could have been.
So, if you own an industrial property in Orange or Los Angeles County, what does all this mean in terms of the value of your property?
We can answer that question this way: the higher the cost of capital goes, the greater the chance that your property will lose some of its value.
If you own an investment property and collect rents from local industrial tenants, you should be concerned about the direction in cap rates, which are currently running at historic lows.
That means investors are willing to accept a lower return on rental income because the yield on the riskless investment (the 10-Year Treasury) is still in the 2.4% range as of this writing.
As the Fed raises its Fed Funds Rate further, the yield on the 10-Year should rise with it, pushing cap rates up on industrial real estate to maintain the same risk premium between the two options.
If your property were to sell at a 5% cap rate today versus a 6% cap rate tomorrow, it will be worth 20% less if you wait until tomorrow to sell.
If you own an owner/user building, its value will be determined by comps for similar buildings based on a per-square-foot price. Prices today are higher than they have ever been due largely to the low cost of capital precipitated by the Fed’s heavy foot.
Lower interest rates mean lower debt service required for each borrowed dollar, reducing the overall ‘cost of occupancy’ for a potential buyer for your building. Currently, the cost of a mortgage is similar to monthly market rent, so many business owners opt to buy instead of lease.
That way they build equity through principal reduction and reap the potential reward for further price appreciation, rather than do the same for a landlord just for the privilege of using space. Yes, being an owner user has its own risks, but a business owner with the resources to make a 10% down payment generally sees those risks as worth taking.
However, as interest rates move higher as expected, debt service can rise beyond the point where owning a building at today’s prices makes economic sense.
At some point, business owners will see the cost of ownership as too costly and revert to a leasing strategy to conserve operating capital.
So, sale demand would likely decrease relative to supply and the market would reset to a new norm. At that point, owners who really want to sell, would be more inclined to accept a lower price and the correction in the owner/user market would begin in earnest without knowing how deep or how long it will persist. You get the picture.
What you should do is totally up to you and your unique circumstances. If you have a long term investment strategy, you may be able to ride out a correction and benefit further from the next recovery.
If your strategy calls for a disposition within the next few years, the dynamics of the market could work against you. This is why you need to be in the know at all times so that your investment strategy takes into account as many variables as possible.
‘Fretting over the Fed’ is a prudent action by all investors, including those who hold real estate assets, as the value of those assets are significantly impacted by mortgage interest rates.
We do not have a crystal ball that will tell you when rates will rise and by how much, but we do have enough experience to know one thing:When borrowing gets more expensive, values are impacted. Click To Tweet
That’s all for now. Next week, we’ll get back to our on-going commentary on wealth, At What Point Is More Just More?