Einstein Died

Einstein died and was immediately wafted to Heaven where St. Peter welcomed him warmly. “Alas,” said St. Peter, “your suite is not quite ready.  So may we invite you to relax in the ante-room for just a bit ? …
But to help you pass the time, we have a young lady here with an IQ of 170 who can discuss with you your Theory of Relativity.” “But if that’s not satisfactory,” said St. Pete, “we can send out a young fellow with an IQ of 180 who can discuss with you your Unified Theory. And if that’s still not adequate, we have someone with an IQ of 75 who can discuss with you the future of interest rates.”
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The matter of interest rates is of great interest to most investors, but it is of very special interest to the Federal Reserve bank whose primary charge is to manage inflation and support full employment. The Fed has a number of tools to accomplish this, but perhaps the most important is the control of interest rates.

Following the collapse of the stock market,  Mr. Greenspan on Dec. 16 , 2008  lowered the Federal Funds Target Rate (FFTR) from 1.0% to 0.0% – 0.25% in an attempt to stimulate the moribund economy. Subsequent maneuvers by Mr. Bernanke (of helicopter fame) resulted in a series of Quantitative Easings ( e.g. QE1, QE2,QE3) whereby the Federal Reserve, in an effort to inject liquidity into the market, acquired mortgage bonds from banks as well as U.S. Treasuries. This artificially suppressed interest rates and resulted in significant inflation in the prices of assets of all kinds, not the least of which has been the price of commercial and multi-family real properties, which  are now seriously overpriced.

In Dec. 2015, the present Chair, Janet Yellen, raised the target range to 0.25% – 0.5%.  Unfortunately, inflation has not been contained at the levels which the Bureau of Labor Statistics publishes (2.1%) and Ms. Yellen was pressured again by rising inflation rates to increase the target range in Dec. 2016 to 0.5% – 0.75%,  suggesting again that 3 increases were possible in 2017. Co-Chair Stanley Fisher volunteered that as many as 4 increases in rates were possible in 2017. Ms. Yellen may have been constrained in her prediction by the memory of the drop in the Dow Jones Index by more than 660 points in Jan. 2016 following the Dec. 2015 increase.

Although the FFTR is an important metric for a number of other rates which use it as a base rate, interest rates for commercial properties rely much more on the 10-year Treasury note rate which has doubled from 1.30% in October 2016 to 2.60% in Feb. 2017. This increase of 130 bps suggests that the “safe rate” is now greater than the BLS [1] inflation rate, which underscores the lack of validity in BLS numbers.

This increase spells trouble for many mortgaged properties whose low interest rate was established for loans over the last 5-8 years. A large number of commercial loans call for adjustments in the interest rate at 5-year intervals. The adjusted rate for renewals is usually determined by a spread, or margin, over the 10-year rate with an allowance for risk. As the 10-year rate increases the total rate (including an allowance for risk) also increases.
In addition to more expensive mortgages, an increase in the “safe rate’ also presages an increase in the capitalization rate, and therefore a decline in market value.

Consider an income property whose value of $4M was established by capitalizing its net operating income of $200,000 @ 5%. An increase of 50 bps (0.5%) in the capitalization rate indicates a value of $3,636,363, a  9.1% decline. An increase of 75 bps (0.75%) reduces the value to $3,478,261, a 13% decline in investment value.

President Trump is known to favor higher interest rates and while he has not ventured any information affecting real estate values, it is fairly certain that mortgage rates will increase and market values will decline. The year 2017 is very likely to be a turbulent year for commercial real estate, but also an opportunity to take advantage of falling prices.
Even Einstein would probably agree.

 

[1]  Bureau of Labor Statistics: http://www.bls.gov

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