September 6, 2018
As the summer season winds down and we reflect on the year thus far, the economic conditions, and real estate conditions going forward, I am reminded of the 1952 movie High Noon.
In the movie, Gary Cooper plays the western town marshal who is trying to rid the town of the local criminal Frank Miller. They agree to a duel at noon. As the movie plays out, there is constant cut away to a clock, ticking ever so slowly but constantly to noon.
We all know that something big will happen at noon. The town hangs in the balance. People are nervous. Some are hiding, others just look out from their homes to see the gun fight. No one knows how this will turn out.
Today the commercial real estate market is approaching High Noon as it relates to values. There will be a real estate “gunfight” over the next 12 months. That fight is between rising interest rates and rising cap rates.
Here is what we know now as we look at the ticking clock:
- Cap rates have been low for a long time – 4.5%-5.5% in many markets.
- Interest rates are increasing. The Federal Funds Rate stands at 2.0% and the 10-year treasury stands at 2.9%. In a recent interview, Jamie Dimon commented that he would not be surprised to see the 10-year rate at 5.0%.
- More Federal Funds Rate increases to come: Based on public statements, the Federal Reserve is planning two additional rate hikes in 2018, likely bringing the Federal Funds Rate to over 2.5%. Many expect an additional three increases in 2019, bringing the rate to 3.0%-3.25%.
Just like the movie, the real estate industry is set for a showdown over one simple question:
“Are cap rates correlated to interest rates or will rising interest rates cause cap rates to increase, thus causing a decline in real estate values?”
There are two schools of thought on this:
- The correlation camp: Cap rates are correlated to the interest rates and must rise accordingly. As interest rates increase, cap rates will increase, and real estate values will decline.
- The non-correlation camp: Cap rates are not correlated to interest rates. Cap rates are based on capital flows, confidence and the historical spread between cap rates and the risk-free rate (which is still high). Interest rates can increase, cap rates will not change, and real estate values will not be affected.
Tick, tick, tick. These two camps are heading for a high noon showdown.
If the correlation camp is correct and cap rates increase, we will see a destruction of equity investments made over the last 3-5 years, as much of this exit underwriting was heavily weighted on stable exit cap rates. It will only take a 100-150 point move to turn a great investment into an equity impairment.
If the non-correlation camp is correct, we will see a continued bull run in real estate values and equity investors will be rewarded.
Tick, tock. The clock is now at 11:30am.
The JCR Hedge:
At JCR we are honest with ourselves about this dilemma. We don’t know if interest rates and cap rates are correlated. Therefore, we have chosen to take the view that they are correlated.
We are underwriting to higher base case cap rates (typically 7%) and we want to see our investors’ principal protected through an 8% cap rate and beyond.
We will continue to watch this “gunfight” but from the safety of our bunker, knowing we will not be hurt if cap rates increase and will do better than projected if they do not.
Thus, we have embedded an “upside hedge”. If we are wrong, our investors will do better than base case (this has been occurring the last few years).
As your partner, advisor and friend, we will be tracking this “gunfight” over the next 12 months.
At this time, cap rates have remained stable and transactions are closing with many equity investors oblivious to the embedded risk they are assuming.
Not at JCR. We understand the risks and we are hedged against them via our stressed underwriting approach.