Real estate is an asset class that is heavily tied to interest rates because most people who buy and own property take on debt to do so. Typically, as rates go down, property values go up and vice versa.
Coming out of the Great Recession of 2008/2009, the Fed dropped the Fed Funds Rate to almost 0% in order to stimulate the economy. This made borrowing money basically free as banks have a 2-3% spread over the Fed Funds Rate, which means property owners were borrowing from the banks at 2-3%. A small rise began in 2016 through the end of 2019, which was quickly halted by the pandemic when the government and the Fed intervened by printing massive amounts of money and dropping rates back to 0%. This led to high inflation which caused the Fed to increase its borrowing rate.
How has this impacted real estate?
For single family homes, prices have not dropped as expected as rates rose. There are 3 major reasons why.
#1 - Most owners refinanced when rates were ~3%, locking in super low mortgages that are fixed for 30 years. These owners will stay put, not selling these homes, because their cost of owning is irreplaceable. If they were to sell and buy another house, their new mortgage rate would be ~7%.
#2 - New home construction is down because the cost of developing is expensive, between higher interest rates and increased construction costs. This contributes to less supply available.
#3 - Institutional companies have been buying up so many homes, keeping the buying demand high and competitive.
In the commercial real estate space, transaction volume has slowed down drastically. Prices have dropped around 25-30% due to the interest rate pressure as buyers have either bowed out of the market due to higher risk or are significantly lower on pricing in order to achieve similar returns to when rates were 3-4%.
Operators who have taken on floating rate debt in the past 2 years have been squeezed. Their cost to own has gone up with higher rates, higher insurance premiums and other operating costs. If that first loan is coming due, there is a high likelihood of a cash-in refinance because their original loan is bigger than a new loan they can secure. These owners either need to get loan extensions on the existing debt, put cash in to refinance or sell at a loss.
The saving grace would be if rates drop enough to offset these scenarios.
30 days ago in July 2024, bank rates began to drop closer to 6% (the 5-year treasury sits around 3.7% and the 10-year is around 3.8%) as we approach the upcoming expected Fed rate cuts in September 2024. The hope is that the economic data will show significantly lower inflation and support more cuts in the upcoming months. This will improve the market by lowering ownership costs while also sparking optimism that will bring people back to transacting.
Other notable factors currently at play are the upcoming presidential election and Prop 33 in California. People get nervous around elections as there is uncertainty at which direction the country is headed. Buyers tend to wait and see and sellers get ancy to sell, which can breed opportunities in the marketplace so long as you are nimble enough to find them.
Prop 33, if passed, would repeal Costa Hawkins then allowing cities to redefine their rent control laws. The fear would be the implementation of vacancy control, which would restrict owners from raising rents to market after a tenant moves out. More information about this can be found by reading this article.
TGG sees this as an opportune time to buy so long as we get price adjusted properties that account for the risks today. We believe the market will be better in the next 2-5 years than it is now. If we are able to secure assets at great price points with executable business plans, we will stay active and diligent in growing our portfolio.
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