With Germany recently joining the Central Banks selling negative-yielding bonds, there is roughly $16 trillion worth of corporate and government debt returning less to investors than they originally paid for them, if held to maturity. The search for positive yield has supported widespread purchases of U.S. Treasury securities from both international and domestic investors. The increased capital flow has kept interest rates low in the U.S., despite an optimistic economic outlook. In addition, the Federal Reserve has issued three rate cuts in 2019, twice amid trade tensions with China. Fears of an impending recession have grown stronger as these variables weigh on the country’s economic outlook.
Against this backdrop, it is safe to assume that interest rates will remain low by historical standards for the near term. However, as I predicted in my 2019 outlook, certain demographic trends will keep rates low for the longer term as well. In the United States, as well as in many developed countries, we are experiencing an aging population. Life expectancies are increasing while fertility rates remain below replacement levels, resulting in an increased ratio of elderly to working-age population. An aging population means more savers and bond buyers driving up demand for treasuries and keeping interest rates low. All this considered, I’ve been getting frequent calls from my investors asking, “What happens to commercial real estate now that we’re lower for longer?”
Mortgage rates tend to travel in tandem with the 10-year Treasury bond rate. During the past 12 months, mortgage rates for commercial real estate have come down by nearly 1% across the board. In my business, where we used to see 4.6%-plus rates for refinancing loans, we are seeing 3.75% for that same product — for the first time in nearly a decade. Not surprisingly, commercial real estate transaction volume continues to grow. According to an analysis of the Mortgage Bankers Association’s third-quarter report, “At the end of the first half of 2019, total commercial and multifamily debt outstanding stood at $3.5 trillion, with multifamily mortgage debt alone showing an increase of 1.7% ($24.4 billion) in the first quarter to $1.5 trillion.” Multifamily originations are projected to hit an all-time high in 2020.
Despite the dip in mortgage rates, cap rates have stayed relatively flat, at 5.6% during the first half of 2019. Cap rates across all major segments, except for the retail sector, which has seen some cap rate expansion, have been largely unaffected by interest rate fluctuations and remain a favorable asset class. That said, the hunt for yield will continue to drive more capital into real estate acquisitions.
In Denmark, where interest rates have been negative for the longer than any other country, the major pension funds have committed to significant investment in their residential rental market as they search for higher returns. The U.S. has some of the highest cap rates across all sectors for cash-flowing real estate in the developed world, attracting an abundance of foreign and domestic capital searching for yield. Cap rates in Europe have compressed substantially after 2009, and have held below 5% since 2014, and even lower across the Asia Pacific. The result? I believe cap rates will compress further. In fact, I can envision a world where Class A and B garden apartments sell for 4% cap rates and stay that way for the foreseeable future.
What about the single-family home market? As previously mentioned, U.S. home buyers have seen some of the lowest rates in history over the current expansion period. Despite a run-up in mortgage rates at the beginning of this year, rates show no sign of ascending to the 5%-plus levels seen before the financial crisis. Will renters finally exit apartments for single-family homes?
A lower-for-longer interest rate environment helps ease housing affordability concerns at the margin. However, there is a trillion-dollar impediment that persists. Student loan debt is at a historic high, with $1.6 trillion in federal and private student loans as of March 2019. This is an increase from roughly $400 billion in 2004. At the same time, home price appreciation has outstripped wage growth across 76% of U.S. markets. The primary factor behind home price appreciation has been the lack of homes available for sale since the recession. Home building activity was slow to rebound after 2008, and new supply been mostly concentrated in the top pricing tier of the market. Until there is a major rebound in affordable homebuilding (which I believe is unlikely without strong government incentives), many will be priced out of home ownership and remain in the renter cohort.
Therefore, I believe that young people in the upper-middle class cohort will buy homes, albeit more than a decade later in life than prior generations. And lower-middle-class millennials and Gen Zers? They will likely stay in apartments or single-family rentals for the foreseeable future.
Since valuations for commercial real estate continue to increase, real estate professionals are left to wonder what could threaten performance and returns. When should we be concerned about an overheating market? The answer: easy lending for new construction. In the early 2000s, we saw lenders offering 90%-plus financing for new construction properties. Housing construction volumes back then were nearly double what they are today. And the carelessness of the big banks led to overbuilding in nearly every market in the United States. By comparison, lenders today typically require 25%-40% equity from a borrower, and equity providers remain fairly disciplined in their allocations. As a result, demand over the past five years has exceeded housing inventory by 1.4 million units, and vacancies are at their lowest levels since 1984.
If we start to see 95% loan-to-cost construction loans and massive supply waves, I would argue that smart capital should stay on the sidelines. For the time being, most markets are absorbing new supply well and commercial real estate cap rates will continue to compress.