Learning to trust the Fed – Freely Floating and FearlessLong–term interest rates are up about 150 basis points since the low we saw in May of this year. The consensus is that with the economy strengthening and the Fed announcing they will taper their long-term bond buying, the bottom we saw in interest rates will not be back in the current economic cycle.
Yet talking to investment brokers, cap rates for apartments and core assets are up only 50 basis points, if at all. Positive leverage, where the cap rate is higher than both the long term interest rate and the debt-service-constant, has occurred very rarely over my career. Usually real estate investors need appreciation in rents and/or values for a project to make sense. With positive leverage, real estate investors can start out with a decent return from day one. This has attracted a huge amount of money to commercial real estate, running up prices and driving the excess profits out of the industry.Core real estate assets shot-up in value and cap rates plummeted. Now, at least on a debt-service-coverage basis, positive leverage is behind us and we are seeing little inflation that we can count on.
So, why are values not falling?The answer lies in how the winning bidders are financing their acquisitions today.
Often the buyers for stabilized, institutional quality, core assets are REITS or large investment funds. These real estate hedge funds have amassed money from pension funds and endowments, where the fund sponsor receives a promotional incentive bases upon the IRR achieved for each asset or based on the performance of the fund in general.Many of the winning buyers today are relying on floating rate debt for a large portion of their leverage, if not funding 100% with funds that float over LIBOR. The big banks are back an are very aggresive. The best borrowers for the best assets can get spreads of 150 BP to 175 BP today for moderate leverage on stabilized assets. With the short-term LIBOR rate stuck at about 25 BP, these investors are borrowing floating rate money at 2.0% or less. It is fairly easy to make the numbers work even at a 4.5% cap rate if your leverage is coming in at 2%:
The Carry Trade: Arbitraging higher long-term bonds, using short-term leverage
The carryb trade is a staple of the non-real estate hedge fund world. With high leverage an investor can make a decent return on its equity by playing the usual upward slope of the yield curve. For the vast majority of time, long-term rates are higher than shorter term rates. This is a great way to make a tidy profit… until it stops working.Commercial property has longer term leases and cap rates generally track longer term bonds. For those of us who were around for the S&L crises, we were taught that lending long and borrowing short is a recipe for disaster.
Yet how many years need to go by with the Fed committed to a near zero Fed-Funds rate, before we learn to believe in it and make money by relying on the Fed to execute on their stated plan.
The current manipulation by the Fed of a free-market for money, takes returns away from those who invest and gives the advantage to those who borrower. This financial repression is a government redistribution of wealth that has gone on for over 5-years. This situation is very likely to continue longer than it should: The Federal Government’ as the biggest borrower of all is getting hooked on this form of financial steroid. Yes, Quantitative Easing will eventually come to a close. However, Janet Yellen, the incoming Chairmen of the Fed is making no noises about changing the near zero percent target for the Fed Funds Rate, i.e short term rates will remain low for the foreseeable future.An investor, who does not take advantage of a clearly manipulated market, can look foolish.
For the real estate fund manager, the issue is really one of disclosure.The pension fund or endowment investor that invests in real estate funds also invests in financial hedge funds. These investors are making returns of the Carry Trade already. The investors are making two forms of profit, (1) a real estate profit and (2) a profit from the Carry Trade, the mismatch of asset and liability maturities. For the real estate fund manger, it comes down to an issue of disclosure; simply layout the proposed leverage strategy for the fund and disclosing the advantages and the risks.
The advantages can be shown with a simple calculation If an investor believes we are will face a near zero LIBOR rate for the next five years, an un-hedged bank floating rate deal creates a borrowing cost of around 2.0% (LIBOR plus 1.75%). A ten-year fixed interest rate today might be 5.0%. With 66% leverage, the 3% rate difference will return an extra 9% per year on the 1/3rd equity. Over a 5 year holding period the carry-trade portion of the investment will return almost half (45%) of the invested equity.
Learning to float fearlessly.
If you believe in the Fed's commitment to manipulate short term rates to the low side, you negotiate your floating rate loans differently. Do not let your bank force you to buy a cap or hedge: if forced, buy the cheapest insurance possible; highest cap and shortest term. For the last 5-years caps and hedges have been a waste of money and given the current higher costs of these derivatives this is overly expensive insurance.
If you follow a freely floating strategy, engage a mortgage banker. More and more investors are using mortgage bankers to create competition among banks and other floating rate lenders. Newmark Realty Capital is glad to help with this strategy.