State of the Economy

The US Federal Reserve has recently announced its plan to unwind its massive portfolio of US Treasuries and Residential Mortgage-Backed Securities (RMBS). The Fed’s balance sheet swelled to roughly $4.5 trillion after years of aggressive bond purchasing, known as Quantitative Easing (QE). It was designed to stimulate the economy by lowering the cost of capital for businesses and homeowners. Whether you are a stock investor, real estate owner or small business operator, you are being affected by the actions of Chairman Yellen and her fellow central bankers.

In 2008, the Fed launched its first round of QE, a seldom-used tool that involves the electronic creation of money to acquire US Treasury bonds and RMBS in order to increase cash flow and lower the cost of capital. As a result, investors began increasing their appetite for risk by chasing higher yields in other asset classes like stocks and real estate. The Dow Jones Industrial Average has more than tripled and commercial property values have more than doubled in markets across the US. Increases in capital flows also lowered the interest rate on commercial and residential mortgages to record low levels. Low borrowing rates forced cap rates to compress to the 5% range. Further, it allowed for positive leverage, as mortgage rates remained in the 4% range. Sounds like QE worked pretty well, though many economists fear the consequences of its reverse effects.

However, now that the economy is in its ninth year of recovery, the Fed has decided that it’s time to finally reverse the process and allow the bonds on its balance sheet to mature. So far, Ms. Yellen has been transparent about her plan to gradually implement the unwinding of the Fed’s balance sheet, keeping volatility at a minimum. Currently, the yield on the 10-year Treasury bond is hovering in the 2.3% range. Last year at this time, it was under 1.6%. Assuming unwinding their portfolio will have reverse effects, treasury yields are likely to rise along with mortgage interest rates which are set based on a spread over the 10 Year T-bill. That could send property values lower.

Here’s why: the capitalization rate, a basic measure of return on a real estate investment, also has a positive correlation to the yield on the 10-year T-bill. An increase in that yield is therefore likely to push cap rates higher, lowering the value of your real estate. Today, you can buy an industrial building in South County at an approximate cap rate of 5%. That makes the spread between the current 10-year T bill yield and cap rate 2.7%. If the yield on the same T-bill increases in the next year by nearly 1% and the spread to cap rates remains the same, it would result in an approximate 20% loss in property value at the same level of income and operating expense. That means a property worth $2 million today, could lose $333K in value, with a 1% increase in cap rates.

As a property owner or potential buyer, it is critically important that you pay close attention to these factors in order to make strategic decisions for your portfolio.

- John Viscounty, The Cargile Industrial Group