Thursday, September 2, 2010

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.

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