Chicago, Illinois, February 1, 2023 – It’s all about the Fed. The Fed raised rates by a quarter point today and announced that another quarter-point increase should be expected at the next meeting. The bond markets responded by dropping the ten-year treasury yield by more than eight percent.
As consumer spending slows on retail goods, the Fed focuses on controlling wage inflation. The Fed’s leadership suggested that a 5% interest rate would help reduce inflation. The new annual inflation target is likely to hover in the 2.5%-to-3% range instead of the 2% benchmark that has existed since the end of the Great Recession. In addition to Fed news, a couple of other “hot” topics realty investors face include negative leverage, yield fatigue and strict underwriting:
Negative Leverage: As long as mortgage rates exceed cap rates, negative leverage keeps investors sidelined. The dramatic bid-ask pricing differential discourages more market liquidity. However, select players bet on inflation protection to lift overall yields during the later years of the projected holding period. Alternatively, unleveraged buyers (e.g., pension funds) remain committed to income-property real estate, especially core and core-plus assets. Also, many investors believe mortgage rates will drop as the economy cools. Cap rates will remain steady due to a limited supply of desirable properties.
Yield Fatigue: Ample funds, but equity yields get absorbed by higher mortgage rates, even with lower leverage levels (e.g., 50% to 65% LTV). Mid-three-percent-or-less yields discourage many investors from such deals plagued by “yield fatigue,” even with the expectation of upside from inflationary profits. Alternative stock market investments gain favor, including publicly held real estate companies trading below private equity prices.
Strict Underwriting: Unlike previous real estate economic cycles, short-term lenders maintain strict discipline for underwriting value-add and construction ventures, particularly for new deals. Banks and other financial institutions worry about balance sheet reserves for existing projects nearing stabilization as regulators monitor portfolios for too many loan extension risks. Takeout lenders and an absence of buyers add more concern as long-term debt burdens owners with higher mortgage rates based on fewer proceeds. As has been the case for much of last year, debt service coverage limits loan proceeds instead of LTV ratios. At the same time, developers are resizing return-on-cost yields to reflect higher debt costs and risk, adding 100 to 150 basis points to exit cap rates.
Mr. John Oharenko, director of The Real Estate Capital Institute’s® director, suggests, “Investors place more emphasis on patience this year. Taming labor and operating costs rank as key factors managing properties, as few new opportunities exist.”