How long do asset prices go up? As long as interest rates go down. It’s as simple as that. When global central bankers mandated zero interest rates (for which there is no historical precedent) it was intended to re-inflate asset prices: stocks, bonds, real estate, etc.
This policy worked admirably. When you make holding cash a liability, you force investors to bid up asset prices for any kind of return. However, this process also works in reverse. When interest rates go up, that big pool of investible cash shrinks. As the return on cash increases, the need to put it at risk for any kind of return diminishes. Therefore, when rates start going back up (which they are doing now) asset prices come back down.
As an investor, what does this mean to you? It means that most of the appreciation you have enjoyed in your real estate assets the last 9-10 years are a result of ever lower interest rates. As that pool of money got bigger and bigger real estate prices went higher and higher. It was a very simple supply and demand equation.
Unfortunately, with interest rates going up now, you can no longer count on this to drive asset prices higher. As money becomes more expensive, fewer people can afford to borrow it. Therefore, your buyer pool shrinks. In turn, demand slackens and prices drop off. In the face of rising interest rates, the only other tool available to increase the value of your real estate is NOI (net operating income). This is just a fancy way of saying you need to be able to raise rents: the more frequently, the better.
Most commercial real estate sells on the basis of cash flow. Therefore, if you significantly increase rent on your assets over your ownership interval, you will increase the price regardless of the interest rate environment. Operating assets such as apartments, self-storage, assisted living facilities, even hotels are best able to achieve this. All other things being equal in terms of keeping them fully occupied, these assets allow you to raise rents as frequently as possible.
Unfortunately, this is also death to long term, flat triple net leases. If you can only increase rents every 3-5 years and the Fed is aggressively increasing short term rates, you are falling behind the curve. You are losing ground from a valuation standpoint because the risk free return on cash or cash surrogates is increasing more rapidly than the return on our investment.
Starting cash on cash return may be higher on retail and office properties now. However, in a rising interest rate environment the likelihood of coming out whole at time of sale is much less. Therefore, you need to determine what is most important, maximizing current cash flow or balancing cash flow against return of principle at program termination.
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Disclaimer
This material and views are prepared solely by the author and does not necessarily represent the views of the its affiliates. Statements concerning financial market trends are based on current market trend, which will fluctuate. Projections are inherently limited and should not be relied upon as an indicator of future results. Historical figures and performance are not indicative of future results. This is for informational purposes only and does not constitute an offer to buy or sell any investment.
DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. There are risks associated with investing in Delaware Statutory Trust (DST) and real estate investment properties including, but not limited to, loss of entire principal, declining market value, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.
Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This information is not meant to be interpreted as tax or legal advice.
