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Yield Curve & 2018 Deal Flow Recap
December 10, 2018
This is an interesting article written back in September about the much-talked-about yield curve through a commercial real estate lens. While most people are talking about the yield curve potentially inverting and how that historically purports a recession (see Pensford Yield Curve Analysis for more) this article focuses on the consequences for real estate. However, for the purposes of multifamily, the yield curve has implications for debt. This article explains how the flatness of the yield curve means the incremental cost of borrowing with more term is small. This is especially beneficial today as I think it is important to borrow with at least seven-year maturity and ideally with fixed interest rates. A bit more surprising, the article claims that since floating rate debt is based off of LIBOR or prime and fixed debt is based on the corresponding treasury, the cost to float versus fixed is converging. In some cases, it is more expensive to float which is very odd considering the market is anticipating two to three Fed hikes. As we’ve discussed before (Valuation & Investing Near the Top), the best way to move forward with acquisitions at this point in the cycle is to buy fundamentally strong assets in growing markets financed with long term, fixed rate debt.
I wrote the above back in September and I don’t think much has changed. However, we have seen a bit of a rollercoaster from the equity markets as well as the US 10T. I still think the Fed will raise rates in December. However, at the Dallas Fed meeting Jay Powell acknowledged the fact that 2019 may see a slow in hikes due to growth headwinds, quantitative tightening as well as the lagging effect of previous rate hikes. I’m really hoping the Fed ends their tightening cycle and assumes a neutral rate around 2.5%. Jay Powell has mentioned the idea of overshooting neutral, but I’m not so sure if I (or the market) agree with that.
Deal Flow Recap
As the year comes to a close, I’d like to take a look back at our deal search from the last quarter or so. We have sourced approximately 165 deals that match our general criteria and underwrote about 80% of them. We made offers on 36 properties and participated in the best and final round of bidding on 7 deals… AND BOUGHT NOTHING!
The market is crazy and crazy deals are getting done every day. While we don’t think the market is going to collapse and everyone buying right now is going to lose their money, valuations are remaining at cyclical as well all-time highs in spite of agency debt moving over 60 basis points higher in less than a year. Additionally, we think there will be more modest rent growth in the next five years compared to the previous five. Unfortunately, investors’ expectations have not lowered to reflect our version of reality and capital is pouring into subpar deals in a fury. As the economist Herbert Stein said, “if something cannot go on forever, it will stop”. However, there is a reasonable argument to be made that the alternatives to multifamily look similarly unattractive and, by comparison, it is still a great place to invest for the long term (again, long term debt can help ensure this goes smoothly). However, I worry about all of the investors who have 18% IRR expectations still in a world that can only deliver 13%.
Another notable topic we have seen in the market right now is the investor appetite for value-add deals has compressed the yields and return-on-cost for value-add multifamily deals to the point that buying stabilized, turn-key properties that are newer vintage (reducing infrastructure risk) is more attractive in many cases. We have seen (and nearly purchased) a turn-key property in Dallas at a low 6% cap on trailing, tax-adjusted financials. A 6% cap may not sound rich but it looks pretty good compared to the “untouched” value-add deal next door, built in the 70s trading at a 4.5% cap! Not only are you taking more risk, but you are also accepting lower cash flow during the first 12 to 24 months of ownership.