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Inflation, Interest Rates & Cap Rates – Where Do We Go From Here

Over the past few years, there has been limitless chatter among investing heavyweights and novices alike about the virtual certainty of dramatic inflation rearing its ugly head as a result of the Fed’s overwhelmingly accommodating monetary policies. Recently I’ve found myself being questioned about the impact that inflation will have on a variety of real estate investments and felt it high time to share my perspective to all of you wonderful investors that take the time to read our newsletter each month.

The key to understanding inflation’s role in determining the future value of a real estate investment lies in the relationship between inflation, interest rates, and capitalization rates (also commonly known as “cap” rates). So first things first… what is inflation?

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in purchasing power which very simply means that when inflation occurs here in the US, our dollars won’t stretch quite as far as they once did in the past. It should be noted that inflation can have both positive and negative effects on an economy. The perception that price levels are growing rapidly can lead to consumers hoarding goods and services for fear that those same items will be significantly more costly in nominal terms in the future. This can lead to shortages and potentially even social unrest. On the other hand, inflation that is more moderate can serve to encourage investment and reduce the likelihood and severity of a recession.

The Role of the Fed

The Federal Reserve was established with three key objectives in mind: maximum employment, stable prices, and moderate long-term interest rates. Recently the Fed’s focus has narrowed in on the first two of those objectives which are commonly referred to today as their “dual mandate”.  With unemployment increasing dramatically in the wake of the Great Recession, the Fed’s response has been to flood the economy with liquidity by making massive, ongoing purchases of both US Treasuries and asset-backed securities (mortgages). The result of this policy has been a prolonged period of interest rates remaining at levels considerably lower than long-term, historical norms.

The general concern today is that the Fed’s unprecedented use of their “printing presses” to stimulate the economy and reduce the unemployment rate will lead to swift increases in the inflation rate which will result in the negative effect of substantial reduction in our collective purchasing power. Bottom line being that our standards of living will be eroded unless we can find a means of growing our wealth along with or exceeding the rate at which our dollars are being devalued.

Economists generally agree that high rates of inflation are caused by an excessive growth of the money supply. One could infer that the huge amounts of money that the Fed is “creating” each month to complete their asset purchases is what will drive the inflation rate up dramatically in the future. I would argue that inflation, at least in the context of where we stand today, is much less attributed to this growth of the money supply and much more to do with the velocity at which money changes hands from one party to the next. The faster the velocity is, or rate at which money moves through the economy, the higher the inflation rate will become.

Inflation Today

Despite popular belief, the inflation rate today is rather subdued with the first quarter of the year coming in at a level just above 1% versus long-term norms of 3-4%. Certain goods and services are likely increasing in price at higher rates, however in aggregate, price levels remain quite stable.

In my opinion, inflation remains subdued today in spite of the Fed’s extremely dovish policies because of two main factors: the “newly printed” dollars are not actually entering the economy at large and US consumers in general remain focused on deleveraging their balance sheets and increasing their savings rates.

The Fed conducts its security purchases in the private market through a competitive process; that is, the Fed does not purchase government securities directly from the U.S. Treasury. The Fed purchases these assets from a variety of banks and other financial institutions. In turn, many of the banks involved in this market have chosen to deposit the proceeds from these sales in segregated accounts with the Fed (picture the Fed as a very big bank) where they are paid a very small, yet meaningful rate of interest. So the bulk of the money that is being “printed” by the Fed for the purpose of these purchases is actually not entering the economy at large and thus not dramatically expanding the monetary supply like many have assumed.

Fed’s Recent “Tapering” Announcement

Recently there have been some positive signals from the housing markets, modest gains in employment and strong performance in the equity markets which likely played into Fed Chairman Ben Bernanke’s recent announcement that the Fed would consider “tapering” their asset purchases sooner than was previously announced. The Fed is tasked with walking a very fine line at this stage – support liquidity in the markets with their asset purchases to improve  overall employment in the United States, BUT also take their foot off the gas pedal early enough to avoid a massive bout of inflation.

If we continue to see gains in the employment figures and in turn, see the inflation rate start to pick up, the Fed will attempt to reduce their accommodating policies and slow down or cease their asset purchases, all with the goal of allowing interest rates to gradually rise to gently slow down the pace of inflation.

Interest Rates Move in Response to Inflation

So now let’s take a step back from the Fed’s recent comments to a more macro look at the interplay between inflation and interest rates. As I mentioned earlier, as the money supply grows and the velocity of money moving through the economy increases, we end up with rising price levels and thus, inflation. In order to slow the pace of inflation, monetary policy is shifted to allow interest rates to rise. As rates rise, borrowing becomes more expensive which can slow down the pace of lending, increase the yield on savings and thus, induce consumers to save more and invest less. As the savings rate increases, money will slowly shift away from risk-assets (like stocks) and into safer investment vehicles like US Treasury notes.

Risk Premium

One of the cardinal rules of investing surrounds the relationship between risk and reward: generally speaking the greater the risk, the greater the opportunity for reward in a given investment. The return on US Treasury notes and bonds is typically referred to as the “risk-free” rate because the US government is considered one of the safest entities to lend to in the world. If you purchase a Treasury bill, note or bond and hold that investment until maturity you stand an extremely high probability of receiving your principal back at the end of the stated duration. The fact that your potential for loss of principal is virtually nil is why these investments are considered to be “risk-free” (please understand that even though a return of principal is generally assured, there are other risks associated with an investment in Treasuries).

So as we look at a potential investment in another asset class such as stocks, corporate bonds or real estate, we must first understand that we will likely be taking on greater levels of risk and therefore should be compensated with the potential for higher levels of return. The difference between the return on a “risk-free” asset and that of another investment like real estate is called the “risk spread”. This spread reflects the additional net yield an investor can earn from a security with more risk relative to one with less risk. For example, if the 10-year US Treasury note has a current yield of 2.25% and a corporate bond of the same duration has a yield of 6.25%, then the risk-spread (or credit spread) is 4%. In this example, the investor is taking on the risk of lending to a corporation rather than the US Government and therefore will be compensated with an extra 4% return in light of the additional risks involved.

Risk Premium in Real Estate – Cap Rates

Capitalization Rates (or cap rates) are one of the best methods for quantifying the return from a real estate investment. For those unfamiliar with the term, a cap rate reflects the unlevered return on an investment property. To calculate a cap rate, one must divide the property’s net operating income (NOI) by the current value of the property. For example, an investment property generating $50,000 of net income (before any debt service) that is worth $1 million today has a cap rate of 5%. If that same $1 million property generates $80,000 of NOI it is said to have an 8% cap rate.

It is important to understand cap rates for this discussion because real estate, as we all know, is not a risk-free investment sector. Thus, for an investor to be incentivized to deploy capital into an investment property, they must gauge the risk associated with the investment and determine whether the additional return from the property warrants the additional risk involved to achieve it. If an investor can get 2.25% yield from the 10-year US Treasury note, they will certainly require a higher rate of return to be properly incentivized to invest in a given piece of real estate.

Cap Rates & Interest Rates

If, and more realistically, when interest rates begin to rise to combat higher levels of inflation, cap rates more than likely will also be affected however the impact will not necessarily be uniform across all types of real estate. Let’s assume we have 3 options for our capital: 1) 10-year US Treasury note, 2) a single-tenant, free-standing retail building subject to a long-term net lease, and 3) a relatively new, class A apartment complex. We will also assume that the yield on the note is 2.25% and both the retail building and apartment complex are currently valued at a 6% cap rate. This means that an investor in either real estate investment is receiving a 3.75% spread (or additional return – 6% cap rate minus 2.25% risk-free rate) to compensate them for the additional risks associated with the property versus the Treasury note.

If the yield on the Treasury note were to double to 4.5% (last seen in October 2007) and there was no immediate movement in the cap rates in our example, the risk-spread between the note and the real estate would shrink to 1.5% (6% cap minus 4.5% Treasury yield). Simply put, the investor is only going to receive 1.5% additional yield in exchange for taking on all the risks associated with the real estate versus the surety and stability of the Treasury note.

In response to the higher return on lower risk investments like Treasuries, a prudent investor would likely seek a correspondingly higher return on their real estate in order to compensate for the additional risks involved. Therefore an increase in interest rates would likely trigger a corresponding increase in cap rates.

Importance of Lease Duration

Investors should note that cap rates and real estate values are negatively correlated; meaning a rise in one will cause a decline in the other and vice versa. If the cap rate on our real estate were to increase from 6% to 8% to reflect higher interest rates in the above example, the value of the real estate would actually decline by 25%. In order for a real estate investor to offset the impact of rising cap rates, one must increase the NOI that the property generates.

If I own a single-tenant, free-standing retail store subject to a long-term lease with modest contractual rent increases (1-2% per year), I don’t really have much if any latitude to increase my NOI and therefore could see my property’s value decline in a rising interest rate environment. On the other hand, if I own an apartment building with leases that are typically 12 months or less, I have much more latitude to adjust my rental rates to correspond to the rising inflation. As I raise rents with the renewal or releasing of each individual unit (perhaps 3-5% or more depending on the inflation level), my property’s NOI should rise to offset the negative effect of a higher cap rate.

Therefore cap rate fluctuations will vary by property type, tenant quality, and, most importantly during bouts of inflation, the duration of leases and ability to raise rents. Real estate sectors with less flexibility to raise rents during inflationary periods will generally have cap rates that are more sensitive to interest rate increases. On the other hand, real estate with more flexibility to raise rents to offset the rise in inflation will generally be valued with cap rates that are less sensitive to higher interest rates.

-Posted by Kelly

 

Kelly Clyde

KELLY CLYDE is a partner and co-founder of South Coast Investment Advisors, LLC and a Registered Representative with Independent Financial Group, LLC. Kelly began his career in the financial services industry in the wealth management arena with Morgan Stanley – continue reading

South Coast Investment Advisors, LLC. All rights reserved. Chris Vizzi, Kelly Clyde, and Michelle Vizzi are Registered Representatives offering securities and advisory services through Independent Financial Group, LLC (IFG), a registered broker-dealer and investment advisor. Member FINRA/SIPC.

South Coast Investment Advisors and Independent Financial Group are not affiliated.
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