Inflation, Interest Rates, 1031 Exchanges and Cap Rates in 2023
With most online news articles today reduced to short videos and bullet points, we have precious little attention-span time for market commentary. Here, then, is our most concise take on inflation, interest rates, the 1031 exchange market and cap rates in early 2023.
As the Prophet famously said, “Much of your pain is self-chosen.” Such is the case with our government-induced inflation. Our elected officials in Washington hit the [TURBO] button on the money-printing machine in a massive over-reaction to the pandemic, whose initial economic turmoil was triggered largely by government policies in the first place. This came on the heels of the Beltway’s prior money-printing initiative, which lingered for years after the Great Recession. Add international logistics and commodity restraints—combined with a war in Ukraine—and you have a perfect inflation cocktail.
When consumer inflation exceeds target levels, our unelected officials in Washington rely on a cutting-edge playbook established by some Brits born in the 1800s: reduce the money circulating in the marketplace by purposely stifling the economy. Much as medieval doctors treated patients by draining their blood (at the risk of permanent organ damage or death), the Fed seeks to lower inflation by draining the financial system of our money. Somehow, the ensuing billions of dollars of lost asset values—not to mention the trillions of dollars of resulting federal debt—are justified by an eventual plateau in the rising cost of milk, eggs and toilet paper. Hooray—your monthly household budget saves fifty dollars, but your IRA loses fifty grand! Clearly, the Fed’s monetary policies are not designed to benefit Americans who invest for retirement or own rental properties.
SUPPRESSION OF PURCHASE CAPITAL
The Fed’s very intended consequence of raising interest rates is to deter borrowing. When an interest-only mortgage rate climbs from 3% to 6%, the annual payment on a $500,000 loan goes from $15,000 to $30,000. For a Millennial couple with a household income of $150,000, their annual interest expense to buy a home just jumped from 12.5% to 25% of their net income. Before the autumn of 2022, most of our clients sold their SFR and condo rentals not to investors, but to owner-occupiers jockeying for limited housing inventory. When these would-be buyers pumped the brakes, rental sellers suddenly lost a major source of demand.
1031 TRANSACTION VOLUME
If neither a buyer nor seller is carrying debt, a 1031 exchange may proceed with little concern for interest rates. However, most buyers need a loan, and many exchange sellers have a loan balance that must be replaced under 1031 rules. Even if you own your rental property free and clear, your potential pool of buyers dried up when the Fed made borrowing prohibitively expensive. Worse, many would-be sellers are unwilling to list their properties at prices below what their neighbors got only a few months earlier. This inevitable human trait—delay in accepting worsened conditions—exacerbates the near-term gap between bidding and asking prices of real estate. Until prices reach an equilibrium, transaction volume suffers.
Capitalization (“cap”) rates are a measure of income expectations relative to real estate values. When cap rates for a category of property go up, it means that buyers expect to receive a higher income stream per dollar invested in the property. If a property’s net operating income remains flat while its cap rate goes up, then its market value will decline. The same principle applies to other income-generating assets such as bonds. Yet with real estate, the factors that affect cap rates are more complicated than financial instruments. Not only do interest rates impact cap rates; available investment capital and perceived operating risk also affect the “spread” between cap rates and Treasuries.
THE SPREAD CAN BE SQUEEZED BUT NOT FLATTENED
In the case of Class-A apartments, for example, recent cap rates have barely budged compared to the rise in T-note yields. This is because large institutions (REITs, pension funds, etc.) continue to invest in the constrained supply of quality properties. And while economists differ on the likelihood and depth of a near-term recession, the historic cost of homeownership continues to support demand for rental housing (the same cannot be said for all sectors of real estate). Provided that the market expects a leveling of interest-rate hikes, we may see a continued squeeze in the average spread between T-notes and Class-A properties. But ultimately the Fed’s actions will force cap rates on all types of properties to rise. Investors generally will not buy real estate with a lower yield than a T-note.
Folks who invested in the last few years cannot rely on “cap rate compression” to drive up future market values. Today’s real estate must rely on increasing income to have any chance of appreciating. If your rental revenue does not keep up with inflation, and cap rates creep up thanks to the Fed, then be prepared for an increased possibility of a price drop in the future. Apartments, self-storage, senior housing and hospitality all have the potential to mitigate cap-rate risk by providing greater opportunity for NOI growth over time.
For more information, please call 1031 Capital Solutions at 1-800-445-5908 or visit our website, 1031capitalsolutions.com.
Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor.
This is for informational purposes only, does not constitute as investment advice, and is not legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
This material is not to be interpreted as tax or legal advice. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax concepts; therefore, you should consult your legal or tax professional regarding the specifics of your particular situation.
There are material risks associated with investing in real estate securities including illiquidity, general market conditions, interest rate risks, financing risks, potentially adverse tax consequences, general economic risks, development risks, and potential loss of the entire investment principal.
Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC-registered investment adviser. 1031 Capital Solutions is independent of CIS and CAM.