Since July 2016, when the 10 Year Treasury rate bottomed at 1.32%, interest rates have risen approximately 1.5%. During that same period, 30-year mortgage rates have risen by approximately 0.75%. Real estate has become more expensive, but does that mean it has become less valuable?

Before answering that question, we need to address why rates are rising in the first place. Recent articles in the WSJ, Bloomberg and The Guardian provide a clear understanding:

Rates appear to be rising because of inflation.

Due to inflation, rates really aren’t going up at all. In fact, real interest rates — the rates that matter — are actually declining.

Real Interest Rates = Nominal Rates - Inflation

Real Interest Rates are most important since they represent the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation.

How do Manhattan apartments react to changes in interest rates?

Take a look at some historical data:

A few data points to note:

1. For the past 15 years, cap rates have generally remained below 3%despite interest rates fluctuating between 1% and 5%.

2. Since 1992, Manhattan cap rates have averaged 62 basis points below the ten year treasury rate. When rates have risen, cap rates haven’t necessarily moved in tandem; the spread typically becomes greater.

That is why we love inflation at Compound. There’s no asset class in the world we would rather own in an inflationary environment than Manhattan residential real estate. Add in some leverage and boom!

Good for Manhattan, bad for the yield chasers.

Investors have been chasing yield for a while now, leading most retail real estate investment funds to market around that current yield. The investments held by these funds are typically located in secondary or tertiary markets that can offer relatively attractive cap rates and relatively high cash on cash returns.

High returns sound great, and are naturally easy to market around. But inflation and rising rates will destroy these investments, because these markets have historically NEVER traded at cap rates less than treasuries and typically trade at significant spreads OVER treasury rates.

We looked at a deal the other day — a nice multi-family property in the southeast — offered at a 5.5% cap rate. With 70% leverage, this deal could generate an 8.0% cash on cash return. But upon doing further research, we realized that this was a market that typically trades at 300–400 bps above the 10 year treasury.

If treasury rates go to 4.0%, and the market maintains its historical spread, the property will be worth a 7%-8% cap rate. Even if rents rise at the rate of treasuries, I’ve lost money. Lots of money. In fact, I’VE LOST 83% OF MY PRINCIPAL!

OUCH.

The moral of the story is that rising interest rates aren’t necessarily bad for real estate. They can actually have a positive effect on the market. However, chasing yield in a market that won’t maintain value in an inflationary environment can result in big losses, even when the short-term yield may appear attractive.

Considering where we are in the real estate cycle, at Compound we are maintaining focus on capital preservation, value appreciation, and asset quality.

About Compound Asset Management:

Compound is a venture capital-backed asset management firm that creates residential real estate funds designed for the next generation of investors.