January 1, 2011Kyle KazanComments 2
Please allow me to wish you a happy, healthy and prosperous New Year. But I would also like to ask you an important question: What do the problems in the European Union mean to you and your investment properties?
Answer: As a sovereign issue like Irish debt hits the news (late November and early December of 2010) where a country like Ireland with $41 billion of tax revenue and debts of $59 billion that will mushroom to $459 billion to guarantee all bank deposits (as part of the EU bailout), it reminds bond investors that other countries share the same risk of default. The bond investors shudder at the risk and those nations respective cost to borrow increases precipitously. Since nearly all of our commercial real estate loans are tied to US Treasury bond yields which in turn determine property values, contagion spreading from European bond markets would have extremely negative results. We’d be facing higher interest rates with reduced equity in our properties.
In Figure 1, note how fast bond yields rose in Ireland and imagine what something similar would do to your investment if US bond yields suddenly rose sharply. At the same time, during 2010 in California capitalization rates went down (causing valuations to go up reciprocally) due to falling borrowing costs. In Ireland, from September to December, bond yields went up 400 basis points which in simple terms would theoretically raise cap rates by 4%. Ugly with panic would be the result.
As I have been opining for some time that higher interest rates are in our future, I imagined what the cash flow of my investments would look like if I had to refinance my current 10 year loans (many are fixed at 6%) to a 200 basis point spread over 9% treasury yield. This would equate to new loans at 11%!
While we don’t live in Ireland, their problems are not dissimilar to those our government faces here in the US. Behind the scenes, the European Union, Great Britain, the US and Japan are feverishly working to assure banks and investors that things are fine. Unfortunately, if these countries were applicants at your building, you wouldn’t rent to them as they live off of their credit card every month. Their income doesn’t support their lifestyle. In other words they make less than the rent as opposed to the 2-3 times we demand from a viable risk.
Because the US Government borrows about 40 cents of every dollar it spends, which is courting economic disaster, there will come a time when those who buy US treasuries will demand more yield for the risk. Without QE2 (the 2nd round of the Federal Reserve’s Quantitative Easing), the 10 year bond yield would likely have gone up already.
We must keep our eye on the blocking and tackling which is day to day management to drive NOI but the other eye should be on the world and how it effects what is the biggest expense for most of us, the mortgage payment. Since the Fed is printing money to keep interest rates artificially low, it is a great time to take advantage and refinance existing debt but not a good time to make a purchase decision based on that low rate. The interest rate manipulation has artificially inflated real estate values.
You may be thinking that with QE2, the value of the paper dollar will shrink and hard assets (commodities and real estate) will be a hedge against inflation. Long term, I certainly agree with that logic but given the pressure on NOI with the very weak economy, I’m a very cautious buyer right now and believe better investment times lie ahead.