BFP Management Blog

Archive: May 2011

Yields to Rise After June 30, 2011

As a real estate investor / fund manager, I focus on the apartment market but also issues which are not seemingly related but do affect purchases and holdings. In other words, I look for undercurrents which will drive market forces. It is certainly difficult enough to make sure that purchases are underwritten correctly so that the management team can achieve the goals that have been set forth without spending a moment looking beyond. Thus far those who have daringly written checks to join me in buying property in far flung locales around the world have been handsomely rewarded as much as for when we bought but also by my cautious if not paranoid search for what can ruin the best laid plans.

What has been my most recent (over the last couple of years) worry? The “Invisible Hand” of our government has manipulated treasury yields artificially low through “Quantative Easing” (QE I and QE II). This allowed the US Treasury to buy its own bonds more cheaply and punished those who choose to save money in the bank and/or who buy US Bonds. I’m sure you’ve noted the paltry interest rate that you are earning in the bank. The intent was also to spur investments into “higher yielding” assets because those savers became restless in receiving a lower return than the rate of inflation. In essence, anyone with money in the bank was ending the year with less buying power than they had when they made the deposit. Bill Gross who is one of the founders of PIMCO (manager of over $1 Trillion in bond funds) estimates that the yields are 1.5% too low.

The positives have been that borrowing rates have been artificially lowered and for those who qualify, mortgages that are fixed long term can remain low for many years to come. For sellers of property, the lowered borrowing costs have boosted values which they’ve enjoyed in higher selling prices.

The danger as I see it is making a purchase decision without factoring in the subsidized mortgage rate. Also potentially problematic is the comparison of current yields on savings and bonds with the cash on cash return on rental real estate. When the invisible hand ends its QE investment program (scheduled for June 2011), bond purchases will need to go from public to private. Should the Fed untether from the Treasury purchases and let the market dictate the price, be ready for higher interest rates along with better yields for savers.

As real estate is not a bond with a guaranteed return on investment, it is traded with a yield that is risk adjusted higher than treasuries. I would expect that Cap Rates will go up as borrowing rates will immediately be affected AND buyers will demand a higher cash on cash return.

Frequent readers know that I’ve had a keen eye towards the single family home market since it is a bell weather of real estate values. As an apartment investor, houses have been and will become a larger shadow market with which to compete for renters. February saw the nation’s median existing home price for housing drop 5.2% from a year earlier.

Even with prices dropping, total inventory of unsold homes rose 3.5% to 3.49 million existing homes for sale. That equates to an 8.6 month supply at the current sales pace (6 months represents a market in balance) and there are also an estimated 4 million foreclosed homes owned by lenders today. Couple those statistics with the fact that approximately 40% of all homes today are sold by someone who can’t pay their mortgage or will not because they owe more than the property is worth. In Figure 1, we see that new home sales hit an all-time low although given that most properties are selling well below replacement cost, it isn’t a surprise.

Figure 1

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While the employment numbers have been looking better of late (refer to Figure 2), there is still a massive inventory of homes to be absorbed. House prices that will continue to decline for the foreseeable future.

Figure 2

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Source: CA EDD

 

With the government treasury subsidy scheduled to end on June 30th and the huge supply of distressed real estate available, I’m becoming more optimistic of opportunities ahead.

In the next issue, I’ll discuss why real estate is my favorite trade for green minted paper.

 

 

 

Kyle Kazan

 

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