Customarily, the “risk-free rate” is considered to be the yield generated by a stable government’s debt. This matters to real estate investors because if you’re going to make an investment and take on additional risk, then you need to be compensated for that risk — earn a spread — above the risk-free rate.
Bond yields are also similarly the foundational benchmark for lots of financial instruments, meaning that when yields go up, so does the cost of other things, like mortgages and real estate debt.
As of August 17, the yield on the 30-year US treasury bond closed at over 5.3%. This was a 19-year high. Howard Marks of Oaktree Capital wrote a great memo on the topic that, as always, is worth a read. Among the factors contributing to higher bond yields, he calls out inflation being “stubbornly higher than is desirable” and the US’s “total lack of fiscal discipline.”
The point of his memo is to once again argue that we cannot repeal the laws of economics without there being consequences. He quotes investor Stanley Druckenmiller who said, “Every basis point of artificial yield suppression is a subsidy to procrastination. Governments defending prices against fundamentals always lose. The only variable is how much they spend before conceding.”
Marks ultimately concludes: “I don’t think the U.S. can perpetually spend more than it takes in and not expect its creditworthiness to be questioned and its IOUs – its currency and Treasury securities – to be disrespected.”
All of this suggests that real estate investors might want to be prepared for “higher for longer” financing costs. That means don’t count on cap rate compression.
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