Where are rates going longer term?
Since March 2010, Mr. Bernstein has served as Senior Vice President, Research, for AH Lisanti Capital Growth, LLC, a registered investment adviser. This commentary solely represents Mr. Bernstein’s views and opinions as of March 20th, 2010, does not constitute investment advice and does not depict the views of AH Lisanti Capital Growth, LLC.
The great response to Noah's last post...and the fact that I missed out on the excellent discussion that followed, prompted me to write this post. I guess the biggest questions from the discussion thread were, Why is the rebound in New York City real estate sustainable? Why didn't we get down to replacement cost on New York City real estate? Why won't we see much lower prices in a future that promises de-leveraging, slower economic growth and a smaller and less profitable Wall Street?
These questions are difficult enough and I will address them in an upcoming piece. For now please look back at "What's UP with New York City Real Estate" for some tidbits on how New York City is very unlike most other real estate markets. Today I just wanted to throw a graph out there and a couple of thoughts on another question which came up which was; whether to buy real estate when interest rates are low or when rates are high? and the obvious follow-on, where are rates going.
Commercial real estate is very bond-like....you get paid to hold it (unless your a knucklehead and use lots of debt and finance it at rates greater than the cap rate). But in contrast to a treasury bond where you lose value (relative to par) when rates rise, and gain value when rates fall; real estate's income stream is not fixed and often increases in environments where rates are rising (I won't get into real rates vs. nominal rates, which is hugely important but way beyond the scope of a quick post). Commercial real estate values are linked to interest rates, as the multiplier (cap rate) of income is heavily influenced by interest rates, but increased income can partially offset the pressure on values from cap rates demanded by buyers increasing with interest rates.
Residential real estate often acts much more like equities. It is n't valued on it's income generation characteristics (in fact appraisals of residential real estate almost never look at this factor), but rather on the hopes and dreams of future value appreciation (and appraisals are based on comparisons to recent transactions) and thus often in a vacuum versus residential rental rates. This may not be true in certain particular markets like Park City, Utah or Myrtle Beach, South Carolina, where much of the housing stock is rented out for at least part of the year and many unit owners are landlords too. But in New York City, despite its being largely a rental market, there is not as much transmission of information between the individual unit rental and ownership markets. (Of course big players with empty buildings do serious rent-up versus sell-out calculations, but I am talking here about individual apartment owners). Also in many markets like New York City, the rental stock is much different than the real estate available to purchase. It has been noted many times on this site, that the search for a home for a family in New York City often results in the purchase of a co-op rather than a condo and certainly either is preferable to most rental units.
One of our posters noted that perhaps it is better to buy residential real estate when interest rates are high and real estate values are pressured and simply refinance as rates fall. As a general supposition I don't have a big problem with this way of thinking. But the following chart should be self-explanatory with regard to where we are in the long-term interest rate cycle (relevant to those looking to buy an asset with a reasonably long holding period using 15 or 30 year money) and what your intermediate term expectations of rates should be. This is of course barring a permanent deflationary spiral like Japan, which would keep us at zero interest rates until we default on our debt and have hyper-inflation - I think we have avoided that outcome but if I knew that I'd be George Soros. (I know all you Wall Street sharpies, know this chart well, and probably see it in your minds when you close your eyes to go to sleep at night, but this is for the benefit of the rest of the populace).
Posted by Marshall
Sun Mar 21st, 2010 08:46 AM
Ok interest rate went up for 20 years peaked and have gone down for 20 years so now what it goes back up for 20 years ? Is that the cycle that is "self explanatory" from the chart ? Where are we over the next 6 months 1 year 2 years Short term I cant see the government doing anything that would push the rates significantly higher There is still plenty of damage to confidence in general. Bank lending is still restrictive and many small businesses are really squeezed. On top of that we have the broken government problem lack of strategic policy and lack of political will to make the necessary fixes.How do you factor that in when we make predictions as to the markets ?
Posted by Noah
Sun Mar 21st, 2010 10:22 AM
great topic Jeff and great comment Marshall. My feeling is, the END GAME where the markets start to really impact the longer end of the curve sending rates noticeably higher is still a bit far off.
The main reason is that the structural issues that we all know still exist under the surface (that are being masked by a huge liquidity trade and acct gimmickery to extend and pretend), will likely ultimately combine forces with the severity of this cycle to result in some type of double dip in the years to come. That very well may lead to a risk averse sentiment, especially if the carry trade unwind is in fact a bubble in formation right now, that in essence CONSTRAINS YIELDS from going too much higher in the medium term; say next 2-3 years??
I do think we can break this down in stages. The era of uber low rates, 4.75%-5.15% or so is likely going to be over very soon with the fed completing their debt monetization experiment. That may bump us up to a new slightly higher range - maybe 5.15%-5.55% or so. So we muddle there for a while. But the real gap up in yields that some expect from end game and bond auction failures, like a move from 5% to 7%, likely wont come so soon for reasons I discussed above. Certainly not from near term inflation expectations. TIPS to Treasury spreads are still not really signaling anything major on horizon.
Now, if this plays out like I think, what happens AFTER that risk averse stage that constrains yields due to flight to quality, is anybody's guess. I just happen to think the gap up in yields that we worry about is more of a 4-5YR+ away risk..just my two cents!
In the meantime, rates will gradually edge higher and so will taxes and if the fed doesn't stop this carry trade, so will commodities and that could cause some demand destruction as margins gets squeezed and people's wallets get crunched by these higher costs.
Posted by jeff
Sun Mar 21st, 2010 04:02 PM
What should be self explanatory is that rates are about as low as they can go. So unless you believe that we are in a deflationary spiral like Japan (we fortunately don't suffer from the same horrible demographics....yet), rates have nowhere to go but up...over any period longer than a year. For this reason I wouldn't expect to get a lot of opportunities to refinance at lower rates. if you do believe we are in a deflationary spiral like Japan...whatever you do don't buy real estate....prices in Japan have been falling for 20 years.
Posted by Marshall
Sun Mar 21st, 2010 07:08 PM
If the rates stay low or moderate for the next 4-5 years that would be ok by me. Im just curious with all the government debt, deficits, obligations pensions and promises etc. How is this going to work out. The prospect of really having to pay for all these governmental obligation with real money and taxes is scarey. I guess we should be greatful our debt is denominated in dollars and we still are the worlds reserve currency. I guess what im asking how much can the US government get away with inflating aways its debts and obligations (same with the states) with out causing our to much of a stir. Ones got to assume that this will be part of our governments strategy. Can we assume the our governmens somehow are going to reform themselves and get its house in order. I mean reigning in some of the spending, curbing some of the pensions makeing some politically tough choices. Or is it going to be business as usual. I guess I love nyc but from a real estate perspective there are concerns. We also have behave sensibly. I think weve gotten to the point where the city government also is trying to grab as much as they can. I know they need the money but times have changed they have to mae it easier to do business in this city not harder. They have ease up on the taxes and cut the harassment attitude. Just try to build something these days. They are crazy with the fines its really harassment. Some attorney should bring some class actions against the city Im sure they are pushing production quotas when it comes to fines. They consider their enforcements wether its sanitation, ecb, building, pvb profit centers. The only profit centers the city has are business that employ people in the private sector. Look at the way the fine schedules have been increased. Look at the real estate taxes. When everything was going up and they could get away with it. Is the city and state going to get its house in order. Or is it business as usual. I think if our governments continues with bad policies it will impact us very negatively in the real estate and in every other aspect of our lives. Im not sure i see the political will to do much. If we can buy some time. There are solutions many of them are pretty obvious. So do we live happily ever after in the real estate world ? Given the different scenarios what are strategies to make some money ?
Posted by jeff
Sun Mar 21st, 2010 09:25 PM
Marshall,
That's a lot to talk to. Let me take a shot at a couple of issues. Can the US government ever pay back everything it owes and/or is committed to paying for? You could really ask, is the government already insolvent? I would probably say no. I have seen lots of companies come back from near death experiences by radical restructurring and this is still a possibility for the U.S as a nation - I'll agree there is no sign of it yet. There are plenty of assets the government could sell. The government itself could be shrunk considerably and entitlments could be cut. Will it happen?, do we have the political will? It's hard to say. On the income side, can our companies and employees ever compete well enough around the world to bring an unfair share of world income back to the U.S. again? Not with currency manipulation by our competitors, unless we totally re-invent the energy market which is the greatest source of potential productivity gain left on the planet....good management technique and aggressive use of automation isn't as much of a competitive edge as it once was. But I would hesitate to count the USA out quite yet...and yes we can always de-value like our competitors, but it will be painful and inflationary. As far as New York City goes, it has lost about half the jobs expected to be lost in the throes of the market debacle, due to TARP. In my estimation a revival of Wall Street of at least a couple of years duration is at hand...whether people like it or not. Will it be 2007-like...let's hope not, but things have turned and I saw a recent survey that 1/3 of money managment companies are hiring again. As for the City it is actually supposed to be running a $3B surplus in 2010 - can you believe it?. Can you "make some money" in New York City residential real estate....I'm on the record saying not likely while people still think that's a real possibility of investing here as a hobby. Maybe once everyone gives up the ghost. At the same time, I don't see any reason why prices have to collapse from here without some kind of exogenous event. So if you believe that one no one has planned for/thought about isn't likely for a couple of years, like I do, and you believe that any predictions going out more than a year are totally worthless in a world changing as fast as ours is....I say, why put off buying a place to live if you can afford it, will get substantial utility from it versus renting and want to? I have no problem with people in this situation buying today - but don't expect to make a bunch of money any time soon. Likewise if I were a seller I wouldn't be in a hurry to take a low ball bid this Spring selling season.
Posted by MeekSheep
Sun Mar 21st, 2010 10:07 PM
The true telling of where the dollar is going to go is with European states selling bonds in dollar denominations. It's clear that they feel the Euro is a stronger currency and that the dollar's intrinsic value is being impacted by the federal debt.
Posted by Marshall
Mon Mar 22nd, 2010 11:51 AM
Jeff I agree I dont see prices collapsing i think the next year or two interest rates remain low to moderate. I also agree looking out more than a year or two that any predictions are probably two speculative to be of much value or guidance. As far a being a seller in my position I will take whatever the market "is" within reason. I also think with the right strategies USA and NYC will be fine. The energy problem is very solvable If we deal with it will also take care of some of our political problems.
Posted by Asia condos
Mon Apr 5th, 2010 05:27 AM
Very nice real estate stuff I ever seen! Thanks for the info.
Posted by coach handbags
Thu Aug 12th, 2010 10:03 PM
your intermediate term expectations of rates should be. This is of course barring a permanent deflationary spiral like Japan, which would keep us at zero interest rates until we default on our debt and have hyper-inflation - I think we have avoided that outcome but if I knew that I'd be George Soros. (I know all you Wall Street sharpies, know this chart well, and probably see it in your minds when you close your eyes to go to sleep at night, but this is for the benefit of the rest of the populace).
Posted by Josh
Thu Aug 19th, 2010 02:47 PM
Interesting way of thinking about buying residential when interest rates are high. I guess every method has value in some way or another.