Where there is fear, there is opportunity!
Anyone who knows me, knows that I tend to look at the positive side of situations and approach the future with hope. It was clear that the current rise in interest rates was coming – it was only a question of how much and how fast. Well… I suppose we know that answer to both those questions now based on what the rate plots are looking like with the Fed. So you may ask, why the optimism. Let me explain looking first at rates and then inventory.
Most lenders price based off of some treasuries based metric whether by a predetermined spread or just their general direction (usually in the form of averaging prior trading days). Right now, it appears there is a very distinct disconnect between the direction overall of treasury rates and Fed rate increases. We have an example over just the past few weeks.
On the one hand the Fed increased both the Fed Funds and Discount rates .75%. While treasuries initially moved up slightly, the move was less than .25%. It seems the markets understand a basic fundamental that inflation looks in the rear view mirror and may not accurately reflect the current situation. So on the one hand, the Fed raises rates and tightens. On the other hand, things like commodities have been moderating – or even in
many cases dropping – over the past 2-3 months. It takes time for that to filter into the economy. Then comes the inflation bomb on Thursday that core inflation eased significantly.
The assumption in the markets appears to be that inflation has finally peaked and will begin to ease over the coming months. As a result, in one day we saw treasuries drop basically .3% – ONE DAY! That was coupled with the Dow rocketing over 1,000 points. The markets simply believe that this data points to lower increases from the Fed over the next 6 months and we may be at the end of this crazy time. Moreover, knowing that inflation is easing means those longer term treasuries are less exposed to price collapse helping maintain their value. In essence, the lower inflation goes, the lower treasuries can go. While that begs the question of Fed intervention by selling off their own treasuries, it’s overall a very good sign going forward. If you look at the 10-year treasury chart over the past three months, you see a very clear top in mid-October, then a flattening and now a steep decline over the past week plus.
Charts may not be the best predictors, but actual data is a good predictor. And to that end, yesterday we saw the PPI (producer price index) piggy back on on the inflation data from last week. And the PPI is perhaps a better indicator since that represents products still coming to market. And if those prices stabilize, voila, lower inflation.
So what does all that mean on interest rates. It likely means do not think about locking in long-term fixed rates right now. Consider shorter terms of 3-5 years with low prepayment penalties so you can refinance once rates drop to a level which makes sense relative to current financing. And that plays right into the second part of this discussion: opportunities in inventory.
As tends to be the case when we see market turbulence, it takes time for potential sellers to sort out the ‘new norms’. Some investors simply run for the hills and sell at very steep discounts. Those are the exception and not the rule. More typically, investors who have held properties for an extended period (5+ years) realize the change in values due to increasing capitalization rates and accept that you seldom buy at the bottom or sell at the top (unless your very lucky or incredibly prescient!). As such, they elect to price the property accordingly and bring it to the market. That’s where opportunity comes in.
Once cap rates have begun to move (stemming generally from the rise in interest rates) and values subside, potential buyers can seize the opportunity to buy on those reduced prices. Given the increase in interest rates, that will still likely require a greater down payment and lower leverage. However, over time as NOI increases, interest rates settle and cap rates begin to drop, then values increase. So within 3-4 years as a buyer (now an owner) you have the opportunity to retire the initial higher interest rate loan (which was on a shorter term), pull equity back out, and take advantage of the lower interest rates. In the end, you can pull the equity while retaining the same monthly debt payment as before since the new rate will be lower. And that’s a winning recipe which we’ve seen with literally hundreds of clients over the years.
All of the above is meant to convey only one thing: do not fear! The winds is finally at our backs again and while markets will remain choppy, in the midst of those rough seas will be opportunities to grow your portfolio by taking the longer term view which the real estate ‘flippers’ miss. Dawn is on the horizon!
