December 11, 2003

Interest rate hike could mean time to sell

  • Short-term investors may want to pull the trigger now
    CB Richard Ellis

    In real estate, craps, roulette or the horses, a prudent investor knows the odds. Today, however, analyzing the odds on whether to buy, sell or hold your real estate investments may be far more difficult than deciding which horse to bet on.

    Your real estate investment is far more vital to your future than that $5 exacta.

    What do we do in periods of uncertainty? Frequently, we do nothing. We wait until some indicator in the market tells us what to do. We wait, watch and observe.

    For some, that may be a mistake. Current market indicators suggest a future trend in real estate values that, in some cases, calls for action today.

    Yields on 10-year U.S. Treasury notes have been trending down for most of the past 20 years. The 10-year Treasury is the benchmark for most commercial and apartment fixed-rate loans. In other words, the price of your next loan will be somewhere in the range of 1.8 to 3 percent above the 10-year Treasury (the “spread”), depending on the type and location of the property, as well as the quality of its tenants.

    Two points are worth noting. First, the current yield is the lowest we have seen in 20 years. This means interest rates for real estate loans are also the lowest they have been in at least 20 years. Second, the mean Treasury rate over the past 10 years (excluding the extraordinary rates in the early 1980s) is 5.9 percent, which is roughly 2 percent higher than current levels. Econometric forecasters will tell you that everything regresses to the mean over time. Accordingly, Treasury yields should move back to 6 percent (or higher), increasing interest rates by the same 2 percent (or more). The only question is, when?

    Why is this important? All things being equal, investment real estate values are correlated to interest rates.

    If interest rates rise by 2 percent, the value of a hypothetical $1 million property will drop by 13 percent, or $127,494. Correspondingly, if interest rates decrease by 2 percent, the value will increase by nearly $180,000. Of course that would require interest rates of 4 percent.

    As a real estate investor, I suggest you consider this question: If interest rates shift over the next two to three years, will they increase or decrease, and by how much?

    If they move down, great! If they move up, will your property's operating income increase at a rate adequate to offset the decline in value? If not, your property will lose value.

    Clearly the current Treasury yield suggests that rates will rise, creating a baseline decline in value. The question of improving operating performance is essentially a question of local market fundamentals.

    If you intend to be a long-term holder of assets, hold and place long-term fixed debt on your properties. Today's wacky market will stabilize and your assets will increase in value, over time, as your rents increase.

    However, if you anticipate selling within the next three years, look hard at the chart. If you look to the future of vacancy and lease rates in your local market and do not anticipate profound improvement over the next 36 months, the odds strongly indicate that selling now is the prudent bet.

    Jim Claeys is vice president of CB Richard Ellis' Multifamily Housing Group. He has specialized in multifamily housing in the Puget Sound area for the past 20 years.

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