It’s always been a question of when, not if.
Everybody knew inflation was right around the corner—in fact, this year may be one of the first times in history that you knew, beyond a shadow of a doubt, that interest rates would rise.
The bigger question was, what kind of chain reaction would ensue? Would cap rates follow in lockstep? Would transaction volume start to slow? Would reborn private lenders suddenly become less competitive against the zombie government-sponsored enterprises?
Ultimately, the question is, how will inflation affect your bottom line? To some degree, the answer depends on how much faith you put into interest rates.
The risk premium has always been a tried-and-true metric for assessing a deal’s wisdom. That spread between the yield on the 10-year Treasury and cap rates has served buyers well for decades—the wider the spread, the better the deal.
It’s the space where fortunes are made or lost, a calculation to boost a buyer’s confidence before taking the plunge. In the frothiest days of the last boom period, in late 2006, the spread averaged out to around 90 basis points (bps), a razor-thin margin. Compare that with the long-term historical average of 300 bps and you get a glimpse of just how ridiculously overheated the industry was seven years ago.
But with the 10-year Treasury hovering at historic lows the past couple of years, the average risk premium ballooned out to a seemingly incredible 400 to 500 bps.
The more enthusiastic in our industry would point to that spread and say, “Now, that’s a healthy risk premium, an unbelievable opportunity. What’s wrong with that?”
What’s wrong is, you’re right: It is unbelievable. So much so that many in our industry have stopped using the risk premium altogether, or tweaked it to replace today’s rates with historical averages.
You can’t be blamed for using what’s always worked in the past. It’s just that, sometimes numbers do lie.
Our federal monetary policy since the Great Recession has produced many happy returns for apartment owners—who would argue against rock-bottom interest rates on long-term debt? But it may have also created some smoke and mirrors on the horizon, resulting in exit strategies that may be more mirage than sand.
It’s not just the risk premium being questioned—our monetary policy has also thrown another old reliable under the bus. Inflation is usually accompanied by rent growth, a great consolation prize for owners, and a dynamic that helps inform underwriting. But the rent-growth momentum this industry has been riding the past couple of years is decelerating, just as interest rates are accelerating.
Still, this upturn has a good amount of gas left in the tank. Many finance professionals believe it’s still a great time to build and buy, and they predict more growth ahead.
But, as you enter budgeting season, keep in mind that interest rates—which can determine whether you enter a deal, how you project rent growth, and, of course, the time line for selling an asset—may not be the most accurate bellwether anymore.
For an expanded summer issue, including stories not seen in the print edition, visit www.housingfinance.com.