There was a time in my life when I day traded stocks as a hobby. Green Mountain Coffee Roasters (GMCR), Wynn Resorts (WYNN), Citibank (C), Sirius (SIRI), and Blockbuster (don’t look that one up) were among my favorites. That time was during the tail end of the recession, and my preferred stocks were some of the riskiest companies being traded. But, I did all right.
For a few years my accountant complained about the sheer volume of trades, complimented me on the wins, warned me of short-term capital gains taxes owed, and was curious about my strategy. I didn’t tell him at the time, but I’ll share it with you now. My secret was… stupidity.
Here’s the thing, I got it right, but I didn’t really know why. The market was highly charged and emotionally driven—so when stocks sold off for no apparent reason, I bought. As you know, the market came back and the result was a gain on most of the stocks. In other words, I got lucky…and that was unfortunate because it wasn’t until a combination of arrogance and ignorance in a rapidly rising stock market purchased me this lesson.
Be fearful when others are greedy, and be greedy when others are fearful.
You probably recognize this quote. With it, Warren Buffet told my story in thirteen words as part of a 2008 New York Times Op-Ed. It took me nearly two hundred to share the same. Brevity is important. That lesson is free, and you just learned it the same way I learned the first lesson—through a painful experience.
An Insatiable Appetite
By most accounts, 2015 is not a fearful time with regard to commercial real estate investments. In an atmosphere of limited supply, low opportunity costs, and ever improving access to capital—net lease cap rates continued to compress. On average, the cap rate for single tenant net lease retail investment dropped to 6.71% in the fourth quarter of 2014 and compressed further to 6.4% at the midpoint of 2015. Cap rates that are touching on historic lows haven’t caused investors pause as $26 billion of product has sold through the first two quarters of this year. This is an increase of 16% over the same period in 2014 according to a JLL report.
Multifamily tells much the same story. As prices and sales volume rose, cap rates fell, dropping 30 basis points year over year to 5.9% in the first quarter of 2015. At this point, the previous peak of 6.5% in 2008 is far in the rearview mirror. Cap rates on garden-style (as opposed to high-rise apartments) properties, which are most prominent in Harrisonburg, fell 30 basis points to 6.2% during the same time period as reported by Real Capital Analytics.
It is pretty clear there is an insatiable appetite for investment property even though, historically, overall cap rates have hovered around 9%. In that same op-ed, Buffet went on to say, “If you wait for the robins, spring will be over.” I might add—if you wait to see the first snowflake, winter is already here. Without question, some caution would be advisable.
Bubbles, Gates, and Risk Premiums
We’ve gone crazy with oversimplified descriptors. Bridgegate, deflategate, servergate, spygate, and even gategate in the UK. This lazy labeling seems to extend to finance and economics in the form of the word bubble. It would be tempting to suggest a bubble as cap rates dip below 2006 levels and set new records, but it’s also likely inaccurate.
Traditionally, the 10 Year Nominal Treasury Rate is considered “risk free” as it is backed by the U.S. government. As it stands now, this rate is hovering around 2%. The difference between the Treasury Rate and any cap rate is known as the spread and is considered the risk premium investors are willing to accept for an investment. For example, assuming the Treasury rate is 2% and a Walgreen’s is purchased at a 6.5% cap rate yields a 4.5% risk premium. In simpler terms, think of it as an interest rate—you would rather receive 4.5% on your savings than 2.5% and so would an investor on an investment.
This is important, because a twenty-five year study of the risk premium would suggest a spread of 4.5% or 450 basis points is healthy and fairly typical. This is especially true as compared to the risk premium during the last accelerated market. Leading up to the crash, the risk premium dropped from its normal average of 4.5% to a low point of 2.1%, which leaves very little margin for adjustment, and that’s a pretty strong appetite for risk.
While we have seen some evidence that aggressive purchasing is occurring as cap rates for some highly desirable investments drop into low 3% range; at this point, we aren’t seeing a careless departure from fundamentals on a large scale. In fact, there is still probably some room for the overall average cap rate to fall.
Still, Something Doesn’t Seem Right.
Some studies have suggested the connection between interest rates and cap rate movement is tenuous at best. Instead, the argument is credit availability, supply and demand, and inflation all play an equally important, and perhaps a more important role than interest rates, in cap rate movement. Yet, none if this gets to the heart of the issue I have with net lease investments, and much less so, multifamily investments, at this point.
My issue is net lease investments just don’t make sense right now. Historically low cap rates, below average rental escalations, and long lease terms all work against the individual investor when projecting out anticipated interest rate increases and inflation—and not just because of a technical breach of a historical risk premium average.
In my opinion, an investor that purchases at these cap rate levels is likely to lose twice. The first loss comes when assuming interest rates will rise over the term of ownership causing net positive cash flow to diminish. Given the long lease terms and fixed escalations, net lease properties are particularly poorly positioned to handle this type of adjustment.
A second loss is delivered when the property is sold. Cap rates are unlikely to remain at or near historically low levels. I think it is reasonable to assume they will trend back toward the historical average. This is bad news for an owner of a property purchased at a 6.5% cap rate. Assuming the purchase of a one million dollar property, the difference in value between 6.5% and 9%, even accounting for standard escalations after ten years is about $125,000 less. Let that sink in—even after you receive 15% more rent over the course of ten years, the property is worth $125,000 less than you paid.
Net lease and certainly multifamily investments can still make sense. That said, a little fear might be wise from a purchaser’s prospective while unbridled exuberance is an acceptable emotion for a seller in today’s market for the exact same reasons.
Tim Reamer provides commercial real estate brokerage and consulting services with Cottonwood Commercial and specializes in retail representation, investment property (multifamily | commercial | NNN), and development projects. Learn more at www.timreamer.com.