Tag: cap rate compression

• Wonderful real estate

  At the highest level, I agree with the premise of this tweet from The Real Estate God. The overarching argument is that one’s main criteria for selecting a real estate market in which to enter should be “the place with the least competition.” And the reason for this is that less competition equals less price discovery, which then equals more mispriced assets and more opportunities to generate outsized returns.

  Going even further, the argument here is that you’re actually taking on less risk by buying mispriced assets in less competitive markets because you can model reality (things like in-place cash flows and market rents) as opposed to betting on the future (things like rental growth and/or cap rate compression). Said in a different way, it’s easier to find deals and “make money on the buy”; and, once again, I would mostly agree with this.

  But in my mind there’s a very important caveat. And it’s akin to the advice that the late Charlie Munger supposedly gave to Warren Buffet: “Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.” While it is true that you might find wonderful pricing in less competitive markets, there remains the question of whether you’re also buying wonderful real estate.

  And I think that’s an important consideration.

  2024.02.15

• A real estate sea change

  Earlier this month, Howard Marks published a memo called “Sea Change“, where he argued, among other things, that it is “nearly impossible to overstate the influence of declining [interest] rates over the last four decades.” In fact, he goes on to say that he would be “surprised if 40 years of declining interest rates didn’t play the greatest role of all” in the success that investors have seen since the 1980s. Of course, the reason the memo is called “Sea Change” is because his overarching point is that this tailwind is now over.

  Let’s consider this in the context of commercial real estate. If you bought a real asset at a 4% cap rate (calculated by dividing net operating income by the price of the asset) and were able to put debt on it at say 3%, you would be receiving positive leverage. Your cost of debt is less than the yield that your asset is generating, and so you are in effect magnifying your returns.

  Now let’s imagine a scenario where interest rates decline even further and somebody could put debt on this same asset at 2%. This is likely to put downward pressure on the cap rate, meaning that somebody might be willing to pay more for the same amount of yield. That is, they’re willing to accept a lower yield. This phenomenon is what Howard is describing in his memo. Declining interest rates tend to create upward pressure on asset values. And in the world of real estate, this is referred to as a compression of cap rates.

  But what happens when things go the other way? Well if you had the same real asset generating a 4% yield, but now the only debt you can find is at 7%, then you are in a scenario where, unless you can afford to pay with all cash, you will be receiving negative leverage. Your cost of debt is greater than the yield that your asset is generating. And that’s the thing about leverage: it cuts both ways. It can magnify your returns, but it will also magnify any losses.

  If the only debt that you can find for your asset is now at 7%, then your 4% cap rate is almost certainly going to need to widen/increase. That is, investors are going to want to pay less for the exact same income stream. This is significantly less fun than cap rate compression, where values just seem to always go up. But, it does also create new opportunities for well-capitalized investors.

  All of this is playing out right now. And it is part of the “sea change” that Howard has called.

  2022.12.28