Must Read: rising interest rate alert

On June 24, 2013 by Phil Champagne

By Phil Champagne, Managing partner at Wren Investment Group, LLC

On June 2nd, we wrote about tremors in the financial world:

Boy oh boy do we have some interesting development. The trend in the yield has not stopped, the interest rate have kept climbing up. In that article, I displayed a picture of the 10 year Treasury yield that rose to 2.1% at the time in just a short order, since its low in the end of April.  Since then, we have just seen a rise to above 2.4% which was a very strong resistance dating all the way back to August 2011! It closed last Friday, June 21st at 2.514%. Now imagine what it means for buyers and sellers in the commercial real estate, a rise from 1.6%. This is almost 1% higher cost in debt service that a potential buyer will have to absorb and gives a corresponding pressure on capitalization rate. Instead of say a 4% interest rate that a buyer might have been offered in early May, current buyer would have to deal with a 5% interest rate. This will translate to a reduction in cap rate of almost 1% (somewhat near 0.75) since a down payment of about 25% can be typically expected. This is not that much, but when you look at that chart, it is the fact it broke through an important resistance that tells me we might be heading towards some new upcoming “interesting” changes.

TNX-June24-2013 Today, it broke above 2.6% before coming down and closing at 2.548%

If this keeps going up and pass 3.2% or even go beyond 3.6%, you can expect some  major shock wave. The reflation they have done in the system since the crash of 2008 has only temporarily delayed the major correction. I find that the best analogy is where we have an alcoholic due for the next drink, the prospect of detoxification is too terrible and starts drinking again. Today’s money unfortunately is a debt, an IOU. With the attempt to prevent a very severe correction in 2008 – yes, it could have been worse, the central bankers have artificially reflated the economy but only to make the next one more major. This prediction is easy, it is timing it however that is more difficult. But the interest rate would be one major barometer to watch for.

Residential real estate in California and Arizona have been rising up again in price, particularly in certain area like Orange County, and the market is already showing signs of bubble, unreasonable price. There are signs those markets are showing signs of fatigue and those rising rates will certainly not help as this is one asset definitely sensitive to interest rate.  See this interesting chart below coming from this article on Zero Hedge:

From ZeroHedge

With central banks comes central planning with all its flaws. Most importantly, we understand that Ben Bernanke needs to have a good show of smoke and mirrors to manage the expectation of the bond market so that their confidence in the bond market and the dollar remains strong. If all took the exit, the rates would be going up madly and we would get quite a crash. You can be assured that the Fed Chairman threat of “tapering” QE in the future is an unfunded threat. If the Fed were to stop printing the $85 billion per month, the rates would be going up so high the US government deficit would climb up drastically to pay for this interest, while the economy tank, and with it a severe lost of income tax revenue for the treasury. But the purpose of such a threat is to reduce the expectation of price inflation in the future by the bond and stock investors.

What to expect next is the big question. If they let this current trend going, we could see a severe deflationary pressure happen much sooner. I’m suspecting they might start distancing themselves from the “tapering” scenario and start talking about “adding a boost” to the current QE program, or whatever fancy term they might come up with. They like to come up with fancy terms such as “quantitative easing” that is nothing more than just printing paper money (or electronic in today’s world).

What’s funny is that even Ben Bernanke himself seems “puzzled” at the dramatic rise in interest rates.  And Bill Gross, one of the biggest bond fund manager wasn’t much impressed about Bernanke’s comment who appears to be “driving in the fog”.

In real estate, particularly in the commercial real estate sector, imagine what this recent drastic rise in yield meant for some ongoing negotiation. From the time a first offer is made where the buyer and the seller agrees on price and terms, to the time where the financing is negotiated with the bank, several weeks can elapse. These last few weeks means that there were likely several contracts being renegotiated with a lower purchase price or simply a buyer pulling out.  A 1% rise in interest rate means likely a corresponding 1% in cap rate increase, hence for a cap rate of 7% jumping to ~8%, it would mean a price drop above 10%. And this is just in the last 2 months. If rates keeps going up, we could hit an “interesting threshold”.

Keep your eye on the interest rate. For commercial real estate, the 10 year treasury bond is key,  you can track it here:
Until next time, have fun investing.

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