Commercial Real Estate Value Today
A Bloomberg article yesterday discussed the relative value of commercial real estate today based on the rates for a 10 year government bond.
Their analysis concluded that because the spread between the two was at its highest level in two years that it implied a buying opportunity for commercial real estate.
That is a confusing overview of the article. Let's discuss what that means in simple terms:
Let's say that as an investor you have $1 million to invest. You wake up, have a cup of coffee, and try to decide where you're going to invest your capital.
A 10 year government bond today yields 2.6%. This is considered a risk free investment because it is assumed the government will always be able to pay you back.
However, you may decide that 2.6% is too low of a return in order to achieve your investment goals. So you look for investments that have a higher return (interest rate), however, these investments are also more risky. (You may not get your money back if there is a default)
This process is called moving out on the risk curve, or yield curve.
For example, stocks (usually) have a higher dividend (interest) payment than bonds. This is because a company can go bankrupt. Same goes for corporate bonds. Higher payments, higher risk.
Now let's look at real estate. The return you receive for commercial real estate is called a cap rate. This is the rate that determines how much (price) you are willing to pay for a building's income.
Right now the average cap rate for a commercial building is 7.2%. Bloomberg now compares that return against the risk free 10 year treasury at 2.6%. As an investor you will get 4.6% more every year by investing in a commercial real estate building. That 4.6% is called the "spread."
On the surface their argument seems valid. However, what if the 10 year treasury yield at 2.6% was overvalued. (I make an attempt on this site every week to explain why it is extremely overvalued)
What if 10 year treasury rates went to 5%? Or 6%? Or 7%?
If you could receive a risk free payment from the government at 7%, what do you think investors would pay for a return on a much higher risk commercial real estate building? Do you think it would be above 7.2%? Of course it would. It would most likely be 10-12%, or much higher.
It is beyond the scope of this article to explain how rates move price, but if interest rates/cap rates rise for bonds or real estate the price of the asset moves down. Think of it like a see saw. Rates up, Price Down.
This is the outcome I expect over the next few years, and it is why I feel that commercial real estate (and the 10 year treasury bond) are still overpriced.
Their analysis concluded that because the spread between the two was at its highest level in two years that it implied a buying opportunity for commercial real estate.
That is a confusing overview of the article. Let's discuss what that means in simple terms:
Let's say that as an investor you have $1 million to invest. You wake up, have a cup of coffee, and try to decide where you're going to invest your capital.
A 10 year government bond today yields 2.6%. This is considered a risk free investment because it is assumed the government will always be able to pay you back.
However, you may decide that 2.6% is too low of a return in order to achieve your investment goals. So you look for investments that have a higher return (interest rate), however, these investments are also more risky. (You may not get your money back if there is a default)
This process is called moving out on the risk curve, or yield curve.
For example, stocks (usually) have a higher dividend (interest) payment than bonds. This is because a company can go bankrupt. Same goes for corporate bonds. Higher payments, higher risk.
Now let's look at real estate. The return you receive for commercial real estate is called a cap rate. This is the rate that determines how much (price) you are willing to pay for a building's income.
Right now the average cap rate for a commercial building is 7.2%. Bloomberg now compares that return against the risk free 10 year treasury at 2.6%. As an investor you will get 4.6% more every year by investing in a commercial real estate building. That 4.6% is called the "spread."
On the surface their argument seems valid. However, what if the 10 year treasury yield at 2.6% was overvalued. (I make an attempt on this site every week to explain why it is extremely overvalued)
What if 10 year treasury rates went to 5%? Or 6%? Or 7%?
If you could receive a risk free payment from the government at 7%, what do you think investors would pay for a return on a much higher risk commercial real estate building? Do you think it would be above 7.2%? Of course it would. It would most likely be 10-12%, or much higher.
It is beyond the scope of this article to explain how rates move price, but if interest rates/cap rates rise for bonds or real estate the price of the asset moves down. Think of it like a see saw. Rates up, Price Down.
This is the outcome I expect over the next few years, and it is why I feel that commercial real estate (and the 10 year treasury bond) are still overpriced.
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