You can’t bring up real estate today without someone yelling, “What about interest rates?” from the back of the room.
Who can blame them? Since interest rates started climbing a few years ago, many areas of real estate have stalled out while the stock market keeps climbing.
But what if I told you that the relationship between real estate and interest rates isn’t what most people – even many skilled investors – believe? And because of this, there are opportunities available today that really shouldn’t exist. You don’t have to take my word for it.
I’ll show you the data, and then you can decide.
The Key Is a Boring Document
At Wide Moat Research, we do our best to leave bias at the door. We analyze the strengths and weaknesses of investment ideas based on the numbers. That enables us to see through the market’s fog and see opportunities others don’t.
Commercial real estate (CRE) doesn’t make money on its own. Without tenants, it’s just an empty building. The property owner (lessor) must rent the property to the renter (lessee).
This lease agreement is critical to real estate investing. In a triple-net lease, for example, the tenant covers the property’s maintenance, insurance, and taxes. That makes life simple for the landlord. Brad has covered the benefits of this structure on several occasions.
A typical triple-net lease may last 10 years and include 2-3% annual rent escalators. This “built-in” revenue growth is great. But it has weaknesses, too.
Pretend you are the fortunate owner of an industrial building in Dallas, Texas. It’s a major logistics hub, so back in 2019 you were able to secure Amazon as the tenant for an eight-year lease with 2% annual rent increases.
By early 2022, the Federal Reserve realized stimulus spending had gotten over its skis and inflation was a real problem. It started the fastest series of rate hikes in its history. The income from your industrial building remained safe with Amazon dominating retail more than ever.
Now, let’s say an identical industrial building to yours across the highway comes up for sale. Amazon even agrees to the same lease terms if you buy it since the location is perfect for them.
When talking to your lender, the mortgage is now priced at 6.4% or a 2.6% spread (Wall Street term for difference) to the 10-year Treasury Bond. Back in 2019 when you secured a mortgage, the 10-year was 1.5%.
The bottom line is simple: the same mortgage on the same property is 64% more expensive today than it was in 2019. Since Amazon wants the same lease terms, you need a steep discount on the new property to match the old one. But how much of a discount?
Using average data for industrial properties, we’d need a 25-30% discount to achieve the same level of cash flow. That’s not great news for the owner, but it means your building may be worth a lot less, too.
This takes us to the next issue higher interest rates cause. They make other investment more appealing. Just a few years ago, FDIC insured CDs yielded 1-2%. Today, it’s possible to lock-in 5% for a few years. That is a lot more competitive to our industrial property.
So, it’s settled then. Higher interest rates are the end of real estate, right? Wait to make up your mind until you see the numbers for yourself.
The Data vs. the Theory
It was just reported that U.S. single-family home prices achieved yet record high with an average of nearly $440,000.
But this doesn’t make any sense. U.S. mortgage rates are the highest they’ve been in decades. Higher interest rates are supposed to equal lower values, not higher.
Yet U.S. residential homes are now worth $49.6 trillion as of June 2024 – an all-time high. That’s many times the U.S. CRE market – and about equal to the entire value of all U.S. stock markets. If higher interest rates are supposed to crush the real estate market, someone has some explaining to do.
To figure out what’s going on, we need to go where the data is: real estate investment trusts (REITs).
REITs are publicly traded entities that own real estate (a small number also focus on mortgages). Due to regulations, they must report key operating and financial metrics every quarter.
That gives us detailed information on all types of real estate from cell towers to apartment buildings to shopping malls. And REITs have been around for several decades, so there is a long track record for us to analyze.
To start, REITs have performed well in general. Over a 25-year span ending just before the pandemic, S&P calculated that REITs outperformed all other major asset classes. This period included three periods of significant inflation. And just like you’d expect, the Federal Reserve increased interest rates each time just like they are now. By looking more closely, we can discover what’s going on.
REITs have outperformed the S&P 500 Index during moderate and high inflation. They slightly underperformed stocks during low inflation, but still generated decent returns.
Inflation increases the replacement cost of any building. If you’ve tried to hire a contractor lately, you know precisely what I’m talking about. As labor, land, and materials rise in cost, existing buildings become more valuable.
Odds are you’ve rented an apartment building or self-storage unit. If inflation causes all local landlords to increase rents, people pay. To increase supply, that new apartment building comes with concrete, labor, and land at today’s inflated prices. In short, a new building can’t compete with an existing one in an inflationary environment.
The worst inflation in modern history was in the late 1970s through the early 1980s. During that period, REITs beat stocks by 91.4%. The second worst (excluding the current example) was in the early 2000s, and REITs beat stocks by 70.6%.
In the late 1970s, the Consumer Price Index (CPI) peaked at 14% in 1980. That caused Paul Volker, the Fed Chairman at the time, to push interest rates to nearly 20%. While this era’s “stagflation” (low economic growth and high inflation) took its toll on stocks and the economy, it was amazing for many types of real estate. Replacement costs were through the roof, driving up prices. Property owners quickly increased rents to offset rising inflation. It was a safe haven in a very chaotic period in American history.
Key Takeaways
Real estate and interest rates are like that couple in a classic high school movie. You can’t quite call the relationship stable, and “it’s complicated” is a better fit. But the data does sway heavily in one direction: real estate and higher rates do well together. That’s because rates tend to rise with inflation, and inflation is good for real estate overall.
Inflation may be steadying, but let’s not kid ourselves. The projected deficit for the federal government in 2024 is $1.9 trillion. Total debt exceeded $35 trillion for the first time ever this month. And that’s the “official” number. No presidential candidate is touching any of this with a 10-foot pole.
And who can blame them? The American people want to have their cake and eat it too (and have the government pay for their diabetes treatment). We expect real estate to benefit from the decline in rates in the coming years. That’ll lower the cost of debt and give property owners a much-needed breather.
But long-term we believe it’s wise to prepare for inflation. And real estate is a proven tool worth keeping in your portfolio. At Wide Moat Research, we can help you find the best real estate investment for what matters to you: safety, income growth, or a hedge against runaway inflation.
Regards,
Stephen Hester
Chief Analyst, Wide Moat Research
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Source: Wide Moat Research