Most real estate assets are financed with mortgages, and the 10-year US Treasury yield is a common benchmark for interest rates on mortgage loans. With the 10-year Treasury yield at 1.7% and the Federal Reserve (Fed) lowering short term rates, we believe there are positive implications for home and commercial real estate values.
Specifically, we believe lower rates are likely to translate into a sustained period of appreciation for real estate assets. In our view, this should result in reduced credit risk in residential and commercial real estate loans. We take a look at the impact of lower interest rates on these real estate sectors.
Lower mortgage rates can make homes more affordable
Historically, one of the main policy tools the Fed has used to stimulate the economy has been the reduction of short-term interest rates. One of the principal conduits of this stimulus to the economy is the wealth created in housing when interest rates fall. Lower interest rates allow homeowners with a mortgage to refinance at a lower rate, or new buyers to afford a larger mortgage.
The chart below tracks the yield of the 10-year US Treasury and the Freddie Mac 30-year fixed–rate mortgage rate. The 10-year Treasury yield is the key driver of the 30-year fixed-rate mortgage rate. As can be seen, the decline in the mortgage rate has been significant, very closely tracking the decline in US 10-year Treasury yields.
US 10-year Treasury yield and 30-year fixed-rate mortgage rates
Source: Freddie Mac, Bloomberg
At the end of November 2018, the mortgage rate stood at 4.81%. At that level, affordability, or the relative expensiveness of financing a home, was becoming more challenging. However, the mortgage rate has fallen since then. As at the start of August it stood at around 3.60%. This 25% decline in rates has positive implications for house prices.
For a $250,000 mortgage loan at a 4.81% mortgage rate, the monthly payment for a 30-year fixed-rate loan would be $1,313. At a 3.6% mortgage rate, the same $1,313 payment would support a loan of $289,000, an increase of 16%. If everyone can afford more, there is potential for home valuations to increase. While not all of the decline in mortgage rates will directly contribute to an increase in home prices, it is an overall support to continued price appreciation in US housing.
Another way to look at this is affordability. Say the homeowner above bought the house in November of last year and refinanced now into the new rate without increasing the mortgage balance. His or her monthly payment would drop from $1,313 to $1,137, a 13% decline. This is great news for the consumer, a key component of the US economy, and increased spending power should add to the strength of this sector. Furthermore, improved affordability opens up homeownership to a broader range of incomes, which leads to more first time home buyers getting on to the housing ladder, another positive for prices (and for politicians).
Housing finance has been highly regulated post the global financial crisis and this, along with lower rates, puts housing on strong fundamental footing. This strength helps to support mortgage backed securities (MBS) - in particular seasoned MBS - as home valuations appreciate.
For the guaranteed mortgage universe (Agency MBS) there is the risk of prepayments on securities with prices that are above par. This, however, is not a credit issue. Our argument is that lower rates enhance the value of non-Agency MBS by reducing credit risk. This is of particular value for securities that have prices below par. As interest rates fall, it is important to differentiate mortgage exposure into credit risk premium versus prepayment risk premium.
How lower rates translate into higher commercial property values
Investors must consider a number of factors when assessing the value of commercial real estate (CRE). One of the most widely-used market indicators is a capitalisation rate, or “cap rate”. A cap rate is often market, or property specific and it approximates the first year’s rate of return for a commercial property.
As a measure of return, the cap rate represents the relationship between the net operating income (NOI) generated by a given property and that property’s value. To bring this relationship to life, an investor seeking a 6.0% return for an office building generating $600,000 in NOI would be willing to buy the building for $10 million ($600,000 ÷ 6.0% = $10 million).
With cap rates and US Treasuries rates hovering around historical lows, the question many investors are asking is: where do we go from here?
There is a direct relationship between cap rates and US Treasury rates, with cap rates historically at a premium to Treasuries. The difference between the cap rate and the US 10-year Treasury rate represents the risk premium of a commercial real estate investment. If risk premiums remain constant, declining US Treasury rates will result in declining cap rates. At the same level of operating income, this would cause CRE values to appreciate.
In the context of our example above, if an investor is now willing to accept a 5.0% annual return for the office building generating $600,000 in NOI, today she would be willing to pay $12 million ($600,000 ÷ 5.0% = $12 million). Based on the current level of interest rates and the prospect of future Fed rate cuts, data suggests that cap rates may decline from current levels and support CRE valuations.
10-year US Treasury yield & cap rates by property type
Source: Schroders, Bloomberg
We expect cap rates to decline with lower US 10-year Treasury rates. This decline in cap rates should provide continued support to CRE valuations. In turn this will provide greater support for private CRE whole loans and securitised commercial mortgage backed securities.