Over the past two weeks, we’ve seen equity markets lose more than 10% of value, realizing the largest weekly point drop in U.S. history. Concerns over the COVID-19 Virus and its impact to global supply chains are real. The virus has now spread to every continent except Antarctica and, in today’s world, every country and product has ties to China. The virus’s inevitable spread has everyone panicked about what the ultimate impact will be, and these fears are showing up in the public markets.
Some investment sectors such as lodging, gaming, and the airline industry have been hit harder than others and rightfully so with moratoriums on flights and the fear of gathering in public places. In Chicago alone, multiple conferences and tradeshows were canceled that would have brought more than 120,000 visitors to the city, and this is happening throughout the world. In early March, investment bank Goldman Sachs revised their growth forecast for S&P 500 earnings to zero for the entire year. We expect the public markets to continue exhibiting tremendous volatility until there is clarity about the full impact of COVID-19 on the economy.
At Origin, we value the assets in our private real estate funds only once a quarter, but this doesn’t mean that their values aren’t moving. However, they certainly aren’t moving to the same degree as the equity markets. As equity markets bounce around by 5% or more per day, we are reminded of why we are in private real estate to begin with.
No one has a crystal ball and we don’t fully know what the ultimate impact to private real estate will be. After ten years of nonstop economic growth, a recession of some magnitude would not be a surprising outcome. However, the global decline of interest rates may actually benefit the long-term outlook for private real estate, but with this we also have to consider the impact of a potential economic slowdown to property level operational performance. Together, these two forces combine to influence borrowing costs, net operating income and capitalization rates. These three variables have the greatest impact on real estate asset values, and we explore their interrelationship below in context of what is happening in today’s market.
Cost of Debt
Cheap debt is positive for both the near and long-term outlook for real estate. Leverage is a part of real estate investing and lower interest rates mean a lower cost of debt. In short, a property will only produce so much cash flow and lower borrowing costs mean less money goes to the bank and more money goes into the pockets of investors. This is incredibly favorable for properties that utilize variable rate debt, are in the position to be refinanced, or are just being acquired. With the ten-year treasury at historic lows, it is inevitable that borrowing costs will follow suit, and we’ve already witnessed this happening. Last week, we received a debt quote of 3.1% on a new acquisition, which is roughly a full percentage point lower than it was 18 months ago. On a $50 million deal leveraged at 65%, the annual interest savings amounts to $325,000. Consistent cash flow is one of the primary reasons to own private real estate, making up a large percentage of long-term returns, and these savings have the potential to increase cash flow to investors by more than 50%.
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Net Operating Income
Real estate investment performance is highly correlated to population and job growth and a slowdown in the economy could impact the operational performance of our real estate properties if the pandemic leads to company layoffs. The flipside to this argument is that people need a place to live and multifamily housing should perform better than most other real estate sectors.
Here’s an example of how a decline in net operating income impacts the value of our investments. A $50 million project valued at a 4.5% capitalization rate in today’s market will produce roughly $2.25 million of net operating income. If the net operating income declines by 5%, the property’s value will decline to $47.5 million, assuming cap rates remain the same. In this example, equity will lose roughly 15% of its value. We are still in a great position with 85% of our equity position intact and the property is producing nearly twice the cash flow needed to service the 3.1% interest rate on the debt. Cash flow to investors will most likely continue uninterrupted.
The disruption of the global supply chain may also impact construction projects, and this is something we will continue to keep a close eye on. These forces can often take months before the true impact is known. If it does impact new construction, this may bode well for existing supply as the cost to build increases, limiting the supply of new product.
Capitalization Rates
The outlook for cap rates continuing their downward decline is very likely but they might tick up before heading down. The cap rate is a function of net operating income (NOI) plus the outlook for growth. If buyers believe that a property’s NOI will be lower by 10% in two years, they must adjust their price downward to account for this, which, in turn, sends the current cap rate higher. The reason why this happens is simple math: The numerator of the cap rate equation (trailing twelve-month NOI) is fixed, but the denominator (the property’s value) is reduced to account for a decline in future NOI, which simply means the formula creates a larger number. Eventually, as property level NOI’s stabilize, cap rates will begin to drift down to account for future growth. This was the same phenomenon we saw in 2008 through 2012.
Why do we think cap rates will be lower in the future? The ten-year to cap rate treasury spread is a great forward-looking indicator of real estate performance. It essentially gauges whether investors are getting paid a premium to take risk. In 2007, this spread was at zero which was a telltale sign of what was about to come. Historically, this spread has hovered between 175 basis points and 250 basis points. The prevailing multifamily cap rate today across the markets we cover is roughly 4.5% and with treasury yields at or below 1.2%, the spread between the two is 330 basis points. If we assume a normalized treasury rate of even 1.7%, the spread is still 280 basis points and well above historical averages. In other words, investors are being more than adequately compensated for the risk of investing in real estate.
Property level performance has generally lagged the economy by six months so it could be some time before slower economic activity shows up in lower rents and occupancy. What’s likely to happen over the next six to twelve months is that transaction volume slows as buyers look for ways to accurately price deals. Those who do transact will need a significant discount in pricing to take on the risk of an uncertain future. Once NOI’s do stabilize, cap rates will likely trend lower into the 4% range and possibly lower. Even if we assume a more normalized ten-year treasury rate of 1.7% and a cap rate of 4%, the spread is still a healthy 230 basis points.
Building on the example above, if cap rates decline to 4% and operational performance isn’t impacted, a $50 million property will increase in value to more than $56 million. That would equate to a 34% gain on equity. If net operating income declines by 5%, the property will be worth $53.4 million and if the net operating income declines by 10%, the property is still worth slightly more than $50 million. Before this happens though, there may be downward pressure on asset prices. Our intention is to take advantage of the coming asset pressure along with the historically low rate environment as we acquire new deals and refinance properties in our existing portfolio.
Impact on Origin’s Investment Strategy and Private Funds
We believe the potential for higher cash flow and lower cap rates more than offsets the risk of lower operational income. That being said, prices will likely trend lower before moving higher. By how much, we don’t know. The good news about this market decline is that real estate is not in the epicenter of the storm. After 2008, the market didn’t fully recover until well after every project was delivered to the market and no new projects were being developed. We don’t have the same supply issues today as in 2008, and a slowdown may be a healthy check and balance on new supply across many markets. Further, interest rates have never been lower, and they tend to stay low even as the economy rebounds, which means we may have a window in the future where we have both higher operational cash flow and a low-interest rate environment. This was very akin to what happened between 2012 and 2016.
The properties and companies that will be most impacted by this pandemic are those that are in the direct eye of the storm and are both under-capitalized and over-leveraged. The blue-chip companies with healthy balance sheets will experience a temporary disruption in operations but will come through the other side just fine.
Like these companies, we are well-positioned for what lies ahead. With more than 1,000 investors and two open private real estate funds, protecting and preserving wealth has been and always will be our primary goal. At our core, we consider ourselves to be managers of risk and practice this in every decision we make from our company strategy to property level acquisitions. Our Funds have been designed to withstand economic shocks because we understand that real estate is not immune to the cyclicality of the market.
We own quality properties in high-growth cities that produce ample cash flow, and we use a moderate amount of leverage compared to most other operators. We have great relationships with our lenders, don’t cross collateralize assets and use non-recourse debt on all our properties. In short, our Funds are built to withstand moments like this. We are certain that the market will be higher in five to ten years no matter what happens, and we encourage our investors to act prudently and invest for the long term.
