One Big Thing
Over the past couple of months, it has become fairly obvious that another round of support will not be forthcoming from the federal government – at least not until after the election. Given our recent economic struggles, conventional wisdom dictates that this sort of news would send bond prices higher, causing yields to drop. However, exactly the opposite is happening. The 10-year treasury was yielding 0.57% back in early August when implementation of a new federal relief package was the consensus view. The 10-year yield has increased to 0.78% today with a package looking highly unlikely.
I’ve found that market reaction to news is often far more telling than the news itself. Back in November 2016 when Donald Trump had just won the presidential election and yields were soaring, I wrote the following in the old blog:
Over the past 6 years or so the US bond market has responded in a remarkably consistent manner to domestic and geopolitical financial turmoil. Every time an even has taken place that has the potential to move interest rates – especially at the long end of the yield curve, they have behaved in the same way: by moving down – even in instances where conventional wisdom was that they would rise. From the S&P downgrade of US debt to the European bailout to the debt ceiling debacle, to the Fed raising short term rates, to Brexit and everything in between there has been an decidedly downward market response when it comes to interest rates and by extension the cost of capital used to finance real estate. However, that could be changing as I write this post.
Going into Tuesday’s election, online betting markets were giving Donald Trump a 15% – 20% chance of winning as were most so-called experts parsing the entrails of opinion polls. We all know how that turned out. Conventional wisdom seemed to be that a (highly unlikely) Trump win would lead to uncertainty and volatility in the markets which would once again beget a flight to safety trade. The prevailing view was that much of that “flight to safety” capital would once again pour into into the US Treasury market, driving yields substantially lower. However, that is not how things have played out. At least not so far.
As I write this, longer term bonds have sold off substantially, leading to higher interest rates and swap spreads have widened. It seems to me that markets are anticipating that Trump will spend a lot on infrastructure and tax cuts and finance both with debt. All of which is being viewed as inflationary. Combine this with the fact that we are already seeing wage growth tick up of late and you have a recipe for rising inflation. Again, I have no clue whether this trend will hold (If I had the ability to accurately forecast interest rates, I’d be on a yacht somewhere rather than writing this blog) and it could reverse at any point due to either economic, policy or geopolitical circumstances. The important thing to me is that the market reacted differently to potential instability and turbulence than it has at any point in the past 6 years and that response, in and of itself is an important signal that change could be afoot.
You may recall that the 10-year yield spiked from 1.8% just before the election to 3.2% by late 2018. Then it quickly reversed course as it became apparent that inflation wasn’t actually going to materialize, eventually settling in the 0.55% range in the 1st quarter of this year when the pandemic shutdown took hold.
If I had to guess, a similar adjustment is happening today, albeit before the election. Conventional wisdom is that Joe Biden will win the presidential election and that will lead to both higher taxes and more aggressive fiscal policy, which, combined with 2020’s previous fiscal and monetary stimulus, will be inflationary. However, assuming Biden prevails, whether or not that stimulative fiscal policy with higher taxation actually leads to inflation is anyone’s guess – just as it was with Trump in 2016.
All that brings us to the real estate market where implied cap rates have a long and well established relationship with both Treasuries and corporate bond yields. As things stand today, the spread between implied cap rates and both of those benchmarks is historically wide thanks to the aforementioned plunge in yields.
Source: Land and Buildings
When this pricing relationship break down as it has in the charts above, there are 4 possibilities:
- Something structural has changed and the relationship is permanently altered.
- Cap rates compress, closing the gap
- Bond yields increase, closing the gap
- A combination of 2 and 3
Since the second quarter, I’ve been fairly vocally in the cap rate compression camp, mainly because inflation has been subdued for decades, despite aggressive central bank policy and the Federal Reserve has committed to keeping the short end of the curve at or near zero for a very long time. That being said, with the recent action in treasury yields despite contractionary fiscal policy has at least opened the possibility that we could see something more like option 4 where cap rates fall – especially in the most desirable product types – while fixed income yields rise a bit.
The reality is that we won’t really know how this plays out for some time. I have a high degree of confidence that the gap will close and we are already seeing cap rate compression in the highest quality pandemic-insulated asset classes at the same time that rates are rising.
With this much uncertainty, we continue to focus on investment profiles that are likely to benefit from cap rate compression but also see rent growth if inflation does indeed heat up. For RanchHarbor, that generally means targeting well-located existing multi-family and infill industrial properties with value-add potential and a strong stabilized yield on cost that is at least 100 basis points above market cap rates. While it is tempting to place market directional bets with cheap capital while debt is cheap relative to cap rates, we believe strongly that this is a time to stick to our underwriting discipline in order to avoid potential headaches if yields whipsaw higher. When it comes to trying to predict the direction and volatility of interest rates, we should all remember what happened after the last presidential election and take a cue from Sergant Shultz of Hogan’s Heroes fame who famously stated: “I know nothing!”
What I’m Reading
In the Right Direction: In September, national retailer rent collections increased to 80% for the first time since the onset of the pandemic, according to data from Datex Property Solutions Tenant Track Report. Globe Street
Balancing Act: Bay Area staffers are moving to less-costly locales to work remotely during the pandemic, triggering cost-of-living salary reductions and stoking debate. Wall Street Journal
Margin for Error: The 2008 Great Financial Crisis was not a typical business cycle slowdown, but rather a a financial event, with no one willing to lend at any price. That has not yet been an issue in the pandemic – except for a short time in March and April – as liquidity remains relatively abundant. IPE Real Assets
The Great Escape: Before the pandemic, an island was typically a vanity purchase that a wealthy person would pursue sometime after retirement. Now, wealthy people are looking to escape cities while still in their working years and island brokers are flooded with buyers. NY Times
Losing Bet: JPMorgan Chase & Co. says the stockpile of developed sovereign debt with a negative yields adjusted for inflation has doubled over the past two years to $31 trillion. This number is likely to grow, which will only intensify the desperate investor search for yield that has benefitted assets like real estate. Bloomberg
Chart of the Day
Source: Visual Capitalist (h/t Scott Barnard)
WTF
Hustler: A rapper was arrested for (allegedly) using PPP funds to purchase a Ferrari because Florida. NY Post
There’s a Lot Going on Here: This headline from the NY Post is really something – Orthodontist Stabs Ex-Fiancée’s Girlfriend Then Pretends to Be Good Samaritan: Cops NY Post
Basis Points – A candid look at the economy, real estate, and other things sometimes related.
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