Rate Hike Head Fake
The last few days I joined a virtual digital asset conference held by Real Vision. There were amazing speakers from crypto celebrities, artists Timberland and RAC, music producers, gaming developers, casino operators, hedge fund managers, former SEC and CFTC regulators, the list goes on. It was an amazing 2.5 days of learning about the Web 3.0. The takeaway is the new blockchain technology will transform society into much less frictionless and cut out the middleman, and all forms of rights to real-world assets will, and at some level has already, transact across the new Web 3.0. Really smart people from many industries are working in Web 3.0 to disrupt the status quo.
What’s on my mind this week?
No I am not a bitcoin maxis and I am still a real estate investor 😊
I am currently reviewing a value-add multifamily opportunity in Seattle. I know you haven’t heard from me talking much about Seattle real estate and I am very bullish. It’s where most of my investments are located. As I am underwriting this multifamily deal, one of the key questions is what valuation projection I should use at the time of sale…say 3 to 5 years from. The two major factors to sale price are rent growth and cap rate. I already addressed rent growth in my previous newsletter. In short, I still believe rent growth will continue due to wage growth …many would say the cause is inflation, but I believe the underlying reason is aging demographics and labor imbalance…more on this later.
The second most important factor is cap rate. Cap rate is basically how much yield the asset can produce. It is intimately related to the US treasury yield, which is sitting around 1.5% at the time of this writing. US treasury is called the “risk free” rate, and there is a risk premium for investing in any risk asset like real estate, so we should see cap rate above the risk-free rate. The risk premium depends on the asset type and the market, and it is directly related to the interest rate. If rate goes up, the asset price would fall… investors would move capital to saving account or buy US treasury.
This brings us to the discussion of inflation. The latest November Headline CPI is 6.8% the highest on record since the 80’s. In the 70’s, when we had rampant inflation, Paul Volcker, the chairman of the FED, was credited to slay inflation by rising interest rate. The current FED chairman Jerome Powell recently retired the word “transitory” to describe inflation and has plans to slow down quantitative easing (QE) which has been holding down interest rate. Many believe the FED will be hiking rates by mid or late 2022. Then the question is should I invest in real estate if rates will go up?
It’s true rates will be going up especially at the short-term of the yield curve, and it has already ticked up after the FED announcement. The FED buys at the short-end of the curve at $120 billion per month and they will be tapering their purchases. However, the market determines the rates for the long-end of the curve. For example, most homeowners borrow at 30 years rate. Interestingly, the 10 years rate has come down. Investors don’t seem to be worried about inflation and may think the opposite is coming. One reason is that the latest bout of inflation is not driven by demand but by supply chain bottleneck. Yes the stimulus has temporarily brought forward demand for goods while we were under lockdown but household saving beginning to deplete and no new stimulus is in sight. Also supply chain issue is getting resolved. It’s my belief that we have seen the highest inflation print (..I am sticking my neck out to make this statement). By mid to late next year, deflationary pressure will build, and the Fed will be forced to reverse the hawkish talk... Our economy is burdened with too much debt, so raising rate without crashing the market is impossible…unfortunately the Fed thinks the market is equal to employment. By providing “forward guidance” that rate may raise is a great weapon to keep inflation under control…. who wants to fight the Fed?
What does it mean to Investors?
Rate is largely going to stay low for the foreseeable future due to the large debt from both private and public sectors and Fed’s current mandate to keep high employment levels. The combination of wage growth and low rates are music to real estate investors. But it is important to be cautious and stress test the deal to make sure you can cash flow and hold the property regardless of the economic conditions. Can rate go up 1.5%? Sure! But I don't think it can be structural.