cap rates

[JohnKrahn]

Looking for some thoughts on what happens to building values when cap rates go up. Assuming that today you could purchase a building for 100,000 with a 6% cap rate and over the next 2 years the interest goes up along with cap rate....new cap rate on same building is now 7%. Now the property value is $86,000....

Any thoughts on how to hedge against this?

 

[Thomas Beyer]

higher interest rates = higher inflation = higher rents = hedge on rising CAP rates !



Since 2005 we have been told "interest rates will go up" .. and then have been lower .. do not count on rising rates in Canada by much unless the federal government goes on a borrowing spree which is UNLIKELY !!



Prime rate might go up / will go up .. bit long term bond rates are set by the market aka supply and demand .. and supply is high and demand not that strong !



There is a LOT OF MONEY looking for a safe home worldwide .. and not many options !



Canadian long term interest rates (i.e. 3, 5 or 10 year fixed rates) will be LOW for a LONG LONG TIME .. like today .. maybe 0.5% to maybe 1% more in 3 or 4 years .. if that !!



Why would they go up ??

 

[Lucy]

I will never agree with Thomas and his likes on this. I was investing and selling commercial/investment real estate when interest rates were 13% and quite the opposite occurs. Rents do not go up they go down. It's astonishing for one to believe that rising rates ONLY affects the few who are marginal on home ownership. The lowering of rates are one tool to stimulate the economy. The raising of rates are a tool used to take liquidity out of the economy. Whe rates rise and money supply tightens, every one os affected. This means Corporations etc. Who also use borrowed money. The economy slows, costs to finance business LOC rise, business slows and people get laid off by the thousands. When this happens, the supply of unsaleable real estate rises and a large percentage of it becomes rental properties as investors who are really just speculators disguised as investors flood the market with listings and when they cannot sell for a profit they put them up for rent in hopes that the market will improve next year.

Tenants also get affected. Since many cannot find or keep jobs, the double up effect happens. Many go back home to live with family. Some double up with with friends and family. But the important thing I see is that many on this board ignore th supply side of rental properties and how it balloons when money tightens. What happens when supply exceeds demand is, prices fall.
I just listed a home yesterday for a Jamaican family who are going back to Jamaica since they lost their jobs and cannot find work here.

With cap rates, when the rates available at the banks rise, the expected cap rates for income properties also rise. I remember when mortgage rates were 9-12%. The expected cap rates were also 8-12% range. This means the value of your income property declines accordingly. How do you think we got to these sky high prices for income properties? Do you really believe cape rates were always 5-6%? Lol!

If you are banking on the rates not rising by any substantial amounts, well this is a different discussion all together where many hyper inflation theorists will disagree with you till the cows come home.

For those that see the opposite, we will have to agree to disagree.

Good luck in your speculations.

 

[bizaro86]

Rising interest rates and their associated rising cap rates are a serious risk to this business, in my opinion.



I can think of a couple of ways to protect yourself, and a few ways to hedge, some of which I've implemented, but I'd love to hear others' ideas.



1) Longer term mortgages. If interest rates increase cap rates will increase, but a low rate mortgage (especially in assumable friendly Alberta) becomes an offsetting asset, allowing it to be used as a concession on terms to sell a property at a higher rate.



2) Stocks of chartered banks. The banks tend to earn higher net interest margins in a higher rate environment, so as rates rise they should become more profitable, and growing earnings should increase their price/dividends. Not a perfect hedge, but not bad either.



3) Inverse long bond funds. These are investments that are designed to move with interest rates, so if rates go up, they should go up as well. They do this by shorting long term government bonds, and with derivatives. These are very risky, don't use them unless you understand how they work and the risks involved.



4) Owning properties that aren't traditional rentals. I've had some success buying undervalued properties in primarily owner occupied areas. These do not usually trade on cap rate. So although higher rates won't help their value, they're not being purchased normally by the "marginal buyer" so they shouldn't be as affected by rising rates as a pure cap rate property (ie industrial/investment/multifamily/commercial property).



5) Aggressive mortgage paydown/cash. While this isn't a hedge in the strictest sense, as your cash won't get more valuable (unless we hit sustained deflation, which I consider unlikely) it does provide a buffer. A property with 50% equity and high interest rates might provide the same cashflow as the same property with 30% equity and low rates. Cash and equity provide options, and staying power. This doesn't protect from capital losses due to higher cap rates, but can protect the cash flow a successful investor would be using to live.



These are just a few ideas I've come up with over time, and I'd love to hear the thoughts of the community on this. While some might not agree this is the most likely scenario (and it might not be) I doubt anyone would say it's impossible either, which makes it rationale to consider a plan for that scenario.



Regards,



Michael



PS I should add that all of these have costs to them. Fixed rate mortgages cost more than floating most of the time. Bank stock isn't a fast growing investment, inverse long bond funds have huge friction and volatility costs, properties that aren't traditionally rentals are harder to find and can be hard to cashflow, and mortgage paydown/cash are both low yield investments, so more property would yield a higher possible end result. All of these options involve trading upside for downside risk protection.

 

[Thomas Beyer]

[quote user=Lucy]Rents do not go up they go down.


All your arguments ARE CORRECT .. no disagreement here !



Of course prices fall if interst rates go up and the economy tanks !!



The point you seem to make is that interest rates are somehow set by the government. They are not. All the goverment can do is make money available by its central bank in large amounts and for cheap, like right now.



The question is: why would this change ?



Interest rates will go up only if the supply of money is tight, or is tightened such as in the booming 80's to curb inflation.



Can I envision a world with 12% interest rates ? Actually, I CANNOT. Not in my lifetime (3-4 decades .. likely more)



We had baby boomers spending and prices growing like crazy in the 80's when we had high interest rates. I do not see that scenario going forward. I see an aging North-American and Europan population, with lots of money to invest. I also see a Canadian government with less borrowing needs .. all scenarios which tell me rates WILL STAY LOW.



If one honestly belived interest rates would go up a lot, one should not be in real estate, certainly not mortgaged.



The only time we will have interst rate is if we have high inflation, thus higher rents/incomes, too ! A BIG IF !!

 

[housingrental]

Cash is a good position

 

[Mike Milovick]

When interest rates go up, cap goes up (price goes down). Historically, the spread between bank prime rate and prevailing cap rates is very consistent.

 

[Thomas Beyer]

[quote user=MikeMilovick]When interest rates go up, cap goes up (price goes down). Historically, the spread between bank prime rate and prevailing cap rates is very consistent.


I think the prime rate is NOT the main driver of CAP rates (or even long term interest rates) .. it is Government bond rates and those do indeed influence CAP rates materially .. since it is easier to make money with no work/risk owning government paper than buying a building.



The question, in Canada, is: will long term interest rates go up materially if the government borrows less ?

 

[bizaro86]

One potential hedge for rising rates I came across recently was the stock of companies that have a significant percentage of their earnings from interest on cash balances.



As an example, Federated Investors (NYSE:FII) is an asset manager with 75% of its assets under management and 48% of earnings coming from money market funds.** With rates at current lows, margins on that money are low/negative. If short term rates increase, they'll be able to increase their margins, which will increase their earnings, and should boost their stock price. Currently yielding ~4%, which isn't a bad use of funds for a business that isn't capital intensive.



Regards,



Michael



**Source of data is a recent article in Fortune magazine