The interest rate story has become annoyingly muddled this year.
Long-term rates have plunged since the beginning of 2014—the 10-year Treasury has fallen from 3.04% on December 31, 2013, to 2.58% as of July 31—defying expectations for a rise. Corporate and commercial mortgage borrowing costs have followed the Treasury lower. Corporate BBB bond rates (as measured by the Moody’s seven-year) have fallen over the same time period from 4.1% to just under 3.5%. Commercial mortgage debt rates have also fallen, driven by both lower base rates and lower spreads. Proprietary survey data from J.P. Morgan Asset Management Global Real Assets (GRA)
shows that 65% of fixed mortgage rates were roughly 4.18% as of July, 60 bps lower than the recent high in September 2013. Lenders also appear to be abandoning rate floors to remain competitive.
That said, Treasury rates have not retested the lows of 2012 (they are currently about 100 bps higher) and are roughly in line with where they were a year ago. Indeed, as of August 8, J.P. Morgan Securities still forecast a 3.0% 10-year Treasury by the end of 2014. The forecast was shifted down 20 bps on June 27, but the rate still has a lot of ground to make up because of the consistent downward trend through 2014.
In this context, it’s helpful to look back at what we wrote roughly a year ago about real estate pricing in the face of higher expected rates. Based on historical cap rate and interest rate relationships and our expectations for (continued) growth in property income, we expected the impact of higher rates to be benign. And even before the recent decline in rates, that turned out to be the case:
Transaction cap rates have not risen. With more than 5% same-store NOI growth in core NCREIF ODCE funds, as well as historically wide spreads, investors have, as expected, been willing to accept similar cap rates over the last year. Cap rates on J.P. Morgan's underwritten transactions generally range from 4.5%-5.5%, which is consistent with where they were a year ago.
Prices have continued to rise. With rising NOI, even at constant cap rates, prices have continued to move higher. The extent of the move varies by data source, but the direction does not. Appraised NCREIF ODCE (unlevered) gross price gains are roughly 5% year over year. Green Street Advisors’ Commercial Property Price Index (CPPI) estimates 7% price growth, while NCREIF’s transactions-based price index estimates roughly 9% growth. Gains vary by sector (apartment price gains have moderated while office gains have picked up, for instance), but the overall picture is of prices rising by 5%-10% year over year.3
By some estimates, a 4% rate may be where we top out.
When we wrote on this subject a year ago, we talked about a 10-year Treasury expected to normalize in the 4.5%-5.0% range sometime in the following five years. With Janet Yellen's ascent to the Fed chair and with some additional uncertainty about whether long-term trend growth (and inflation) may be lower than previously assumed, two important changes in expectations may have occurred. First, the equilibrium level of the 10-year Treasury—which is a function of expectations of long-term real growth and inflation—may be lower. By some estimates, a 4% rate may be where we top out. (For perspective, rates briefly passed 5% in the last cycle.) Second, the path to that equilibrium may be more prolonged.
All this means that required returns across risky asset classes will tend to move lower as market participants price in lower risk-free rates for an extended period. So let's put that in the context of what we wrote a year ago about underwritten IRRs.
Question: Are today's [July 2013] sub-7% IRRs sustainable?
In July 2013, we concluded that the sustainability of IRR levels was dependent on Treasury rates:
If Treasuries were to settle below 4%, 7% IRRs should be comfortably sustainable. Debt would remain accretive.
If Treasuries increased to 4.5%-5.0% (J.P. Morgan assumptions ),4 IRRs would be sustainable but tight; some underwriting near 6% would be pressured. Debt would become only modestly accretive.
If Treasuries rose above 5%, property income growth would need to exceed GRA Research’s current expectations to prevent significant downward pressure on prices.
Last year we asserted that the correct real estate risk premium to the 10-year Treasury was 200-300 bps. If we are now closer to the first scenario (a 4% equilibrium Treasury), that would be consistent with IRRs in the 6%-7% range—exactly the level to which they have fallen (high quality core assets are priced to 6.0%-7.0% IRRs [unlevered] on J.P. Morgan GRA underwriting). The market appears to be pricing to a lower Treasury path. In this context, sticking to unreasonably high IRR expectations would mean forgoing real estate that would potentially produce a reasonable spread for years to come. Indeed, while IRRs are about where they were at the prior market peak of 2007 (not a comforting benchmark), in the context of both current and expected future interest rates, real estate does not appear to be overvalued.
One way to illustrate today's pricing vs. the 2007 market peak is to compare underwritten IRRs to market expectations of equilibrium interest rates. Exhibit 1 shows five-year-ahead forwards on 10-year Treasuries. This comparison provides a sense of both how much lower market expectations of long-term rates are today (3.4% vs. 5.0%)5 and how much more cushion there is in today's IRRs. By this measure, the spread was 184 bps in 2007 vs. 329 bps today.
It is also useful to put today's private market IRRs in the context of comparable risk assets. As mentioned earlier, intermediate BBB bond rates of 3.5% yield a 324 bps spread for core real estate; in 2006-07, that spread was closer to 85 bps. The spread to high yield bonds is even more favorable and provides the most striking contrast. The Barclays Global High Yield Index averaged 5.7% in July, a strong bounce back from 5.0% in May. By contrast, in early 2006 core IRRs were actually lower than junk bond yields (a useful warning sign?). The sharp increase in yields has brought the spread down to 100 bps, which is still sizable. Finally, the recent run-up in REIT pricing—which has largely erased the net asset value (NAV) discounts that opened up in 2013 when interest rates started to rise—suggests that equity markets are once again comfortable pricing in the current level of private market IRRs.
Exhibit 2 summarizes the relative IRR spreads in July 2014 vs. September 2007, the low in underwritten IRRs in the prior cycle.
This is all well and good, but it's also important to examine how realistic current IRRs are. That is, do IRR levels look fine only because we are assuming unrealistic rent and NOI growth? One way to illustrate net income growth assumptions is by comparing underwritten IRRs with going-in cap rates.6 The difference between them is (roughly) equal to expectations of annual net cash flow growth.7 Exhibit 3 shows that spread through time on J.P. Morgan underwriting. That spread today is roughly 140 bps. In 2007 through early 2008, that gap was closer to 190 bps. So there was more net cash flow growth assumed in underwritings at the peak vs. today. Also worth noting: at roughly 4.2% fixed rates, commercial real estate debt remains accretive on a cash flow basis (whereas in 2007 it was generally only accretive on a "stabilized" basis once aggressive NOI assumptions were included).
So there are three key takeaways vs. 2007:
Today's IRRs appear to have a substantially wider spread to market expectations for long-term equilibrium rates.
Those IRRs appear to have substantially wider spreads to comparable risk assets.
Those IRRs embed less fulsome cash flow growth assumptions.
The story is not all comforting, however. Although IRR spreads appear reasonable, they are on the narrow end of the reasonable range for assets pricing closer to 6% IRRs. That suggests less cushion in pricing should NOI expectations shift suddenly (as they will whenever we enter the next recession). This is the double-edged sword of more institutionalized and efficient real estate pricing: potentially increased price volatility. This is one reason we think higher interest rates would be a good thing for the market. If debt costs and required returns rise along with interest rates, investors would bid up prices less. To the extent that the market price peaks (whenever it does) at a lower point than it otherwise would, the subsequent correction in prices would be more moderate (along the lines of 2001 vs. 2009).
Moreover, interest rate expectations are, obviously, not set in stone. There is a growing concern in many corners (which we share) that the Federal Reserve's low rate policy is contributing to bubble risks, particularly in light of the unexpectedly rapid decline in unemployment over the last year. An August 7 Wall Street Journal poll of economists found that when asked what they saw as the greater risk—the Fed raising rates too soon or too late—90% of respondents said "too late" while only 9% said "too soon."8 It is not inconceivable that the Fed ends up being forced to raise rates more aggressively than it currently wants or plans to do. And as we also argued in the previous paper, the more that such an action catches markets by surprise—as it did in 1994—the greater the risk that near-term real estate pricing will be adversely affected.
So the bottom line is that we think pricing is full but still reasonable and don't feel we are in a bubble. That said, if transaction pricing accelerates beyond property income growth—and we think higher interest rates would help in preventing that—the risk that values push into overpriced territory will increase.