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Same Story, Different Words…

February 2021 Insight

If someone was bored enough and had enough time, they could read through years of Altus Insights on our website. In its current form we have been producing a monthly Insight since 2010. Prior to that, and going back to around 2005, there were similar emails sent out, though not as structured in format nor timing.

Anyone that read through the archives would find more articles written about interest rates than any other topic. They may not be fun, they may not be exciting, and as the mechanics of the debt markets whose pricing is based on these interest rates is opaque, the topic can be confusing even for industry insiders.

Despite all those past interest rate editions, and despite the understanding that readers eyes are already glazing over just having been told interest rates will again be the topic of this month’s Insight topic, I am going to dive into interest rates yet again. Interest rates are just too important to everything we do in investing and business to not have at least a high-level understanding of what is going on.

I truly believe that a strong and equitable economy is key to a prosperous society. If an economy isn’t strong, then it isn’t creating enough goods and services to allow artisans, performers, etc. to be compensated for their trades; and society is much worse off without art, sports, music and other such things that aren’t found in the first level of Maslow’s Hierarchy of Needs. A strong economy creates quality of life.

Even if an economy is strong (as has been the relative case over the past decade), if that economy isn’t also equitable, winners and losers are created by and through cronyism, nepotism, and statute, as opposed to effort, skill, and fortune. A widening rich/poor (or higher earner/low earner) gap leads to despair and social tension. The quality of life produced by a strong economy isn’t available to all within the society, and there is a sense that there is no opportunity to reach a level of success to enjoy those life qualities. This is very much what we have been experiencing here in the US (and many places throughout the western world) over the past several years.

Interest rates are in fact the price of money. Or more specifically, the price that one person will allow another person to use their money. With money being used on nearly 100% of transactions in the US economy, the price of accessing that money has a huge impact on the wellbeing of the economy, and in turn, society. For the past few decades (certainly accelerating since 2008) the Federal Reserve has had a huge impact on interest rates. With the Fed setting overnight lending rates and buying treasuries (through a work around mechanism) to impact short term rates, they have instituted price controls in our economy. With ongoing discussions of yield curve control, should it come to pass (I am betting that it will come to fruition), this price control will be strengthened.

Whether price controls in our economy are a good or a bad thing is matter of opinion, and only in the future will we be able to look backwards to see if the benefits of price control outweighed the costs. But one thing we know for sure is that price controls result in an inefficient allocation of resources. Price discovery is made much more difficult, if not impossible, when price controls are in place.

In addition to being the price of the use of money – and the single most important price in the world – interest rates are also a gauge of risk. Without price discovery the risk definition mechanism inherent in free market interest rates is damaged. Risk, in and of itself, is not a bad thing. Misunderstanding or miscalculating risk (and there are many reasons this occurs besides just price controls) is where we get into danger.

In an efficient economy without price controls, the pricing of what we are buying, and especially interest rates, provides a constant feedback loop that becomes part of our subconscious understanding of what is going on around us. With price controls in place, we need to move away from trusting our subconscious to really understanding what is going on the best that we can. There is no way a single Insight can provide a deep understanding of interest rate mechanisms, but maybe we can peel back opacity just a bit as it pertains to investment real estate.

As most readers know, capitalization (cap) rates determine a markets perception of value for any generic investment property. But cap rates change over time. Why?

Cap rates are made up of two different inputs. The top layer is the spread that investors will accept between the property returns and the interest rates obtainable at any point in time. This spread may grow or shrink depending on investor liquidity or perception of risk. The higher the liquidity in the market, the lower the spread. The higher the perceived risk in the market, the larger the spread.

The other input is the interest rate available to the investor. While there are all kinds of inputs that affect specific interest rates (location, age of property, loan to value, etc.), the majority of the interest rate determination consists of two underlying inputs. The first is the spread that lenders are willing to take over and above an index, and the second is the index itself.

Like the spreads pursued by equity investors, lenders also price their product (debt/interest rates) based on profit margins. And like investment spreads, the spreads between the offered interest rate and the underlying index are impacted by liquidity and perception of risk.

Different lenders use different indexes, but a common proxy, and maybe the most followed index in the US real estate investing world, is the Ten Year Treasury. Ten year pricing is likewise impacted by liquidity and risk, but here the Fed is able to have substantial impact onto the pricing itself, where they have implicitly shown they were willing to let the Ten Year trade within a band of 60 – 100 basis points, at least up until recently.

Market observers will note that interest rates, as measured by the Ten Year Treasury, have increased dramatically over the past several weeks, at least on a percentage change basis. Last August rates got as low as 52 basis points (.52%) and then mostly stayed between 60 and 70 basis points through the third quarter. Rates then rose a little to trade between 85 and 95 basis points for most of the fourth quarter. Nothing overly dangerous here. Rates adjusting over time can be absorbed by the markets. But since the end of January rates have increased 50% (on a percentage change basis). That is a big deal. So far as I can tell the Fed is withdrawing some if its pricing support, meaning that rates are free to run upward. This does not appear to be a change in the philosophy or acceptance of future price control, but rather part of what the Fed considers acceptable.

Let’s circle back to cap rates. Very generically speaking, an individual property’s valuation is the net operating income divided by the cap rate. NOI goes up and cap rates stay the same, then the property market value goes up. If the NOI stays the same and cap rates drop, then the property market value also goes up. But the reverse is also true. If NOI stays the same (or goes down) and cap rates go up, then the market value of the property goes down. When interest rates change over time, increases in cap rates can be absorbed by increases in the NOI, usually through rent increases.

As defined above, cap rates are determined by the underlying interest rate index (the Ten Year), plus the lenders margin, plus the investors margin. If the lender and investor margins don’t change, then a change in the interest rate has a direct impact on the cap rate, and thus the market values. Interest rate up, cap rate up, market value down. So far lender rates have compressed enough to offset the increase in the index. How long lenders are willing to do this is yet to be determined.

With interest rates as low as they are currently, the impact of changes in the underlying rate is greater than it is when rates are higher. Below are examples comparing current interest rates (1.5% Ten Year) to the historical average (5.69%) with a .6% rate decrease to simulate the change in rates since over the summer. For this example, lending and investing spreads are assumed constant.


Ten Year: 1.5%

Lender Spread: 2.25%

Interest Rate to Investor: 3.75% (1.5% + 2.25%)

Investor Spread: 1.5%

Cap Rate: 5.25% (3.75% + 1.5%)

NOI = $1,050,000

Market Price = $20,000,000

Loan Amount = $14,000,000 (70% LTV)

Investor Yield = 4.53%

If the Ten Year rate drops to .9% to maintain the same yield, the price of the asset increases to $21.26 Mil, or an increase of just under 6%.

Historical Average:

Ten Year: 5.69%

Lender Spread: 2.25%

Interest Rate to Investor: 7.94% (5.69% + 2.25%)

Investor Spread: 1.5%

Cap Rate: 9.44% (7.94% + 1.5%)

NOI = $1,050,000

Market Price = $11,122,881

Loan Amount = $7,786,000 (70% LTV)

Investor Yield = 11%

Compared to the impact of a .6% change in the Ten Year at current rates, a .6% drop in rate from the 5.69% historical average only impacts the value of the property 3.7%, substantially less than the impact at today’s current rates.

And we are only talking about a relatively small absolute move in the index of 60 basis points. We are also ignoring other impacts, such as higher underlying rate environments that usually push investor return expectations higher (see above comparison of the 4.53% versus 11% yield comparisons). For rates to move 50% (on a relative basis) in a month it is a huge change in a short amount of time, but it really isn’t that large of a move in rates on an absolute basis. If inflation expectations solidify, we could easily see larger moves than these in the coming months. Larger upward interest rate moves + change in return expectations necessarily means considerable reductions in market valuations. This impact will primarily affect the investors that have to sell (or refinance), not those that are in it for the long haul, assuming those in it for the long haul have locked their interest rates well into the future.

Who knows what the future holds. Maybe in a future Insight I will share my opinion of where inflation and rates are going. But my opinion and $3 will get you a Starbucks coffee. The important thing is to understand the possibilities and make decisions based on an unknown future, while also understanding how changes in conditions can impact investment returns.

Happy Investing.

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.