Beth Mattson-Teig at National Real Estate Investor writes “There is a correlation between the bond market and commercial real estate, and that could mean that there are some definite changes ahead. The changes in BBB and BB rated bonds are most relevant to the real estate market. To that point, the low investment grade BBB and high non-investment grade BB bonds have seen yields rise over the past several months.
“BB bonds in particular have seen yields increase by more than 120 basis points, climbing from 4.52 percent in early March to a range between 5.71 and 6.22 percent during the first two weeks of October. BBB bonds also have seen a modest uptick of about 50 basis points, rising from 3.55 percent in early February to a current rate of between 3.98 and 4.12 percent.”
Low investment grade BBB and high non-investment grade BB bonds and real estate are two very different, but comparable investment vehicles. Low investment grade bonds carry higher risk, because they are lower quality but liquid and stable investments, but there is no upside other than the stated rate. Real estate is highly illiquid which increases the risk to that of BBB and BB rated bonds, but there also are some added benefits in being able to take advantage of property appreciation and net operating income (NOI) growth.
So there is not a direct substitution, per se,” says Ronald F. Greenspan, senior managing director and co-leader of the real estate solutions practice at FTI Consulting in Los Angeles. The bigger impact is that the available yield in the bond market influences what investors demand and expect in their real estate investments. The uptick in interest rates for BBB and BB bonds suggests that private market real estate prices could decline in the near future. Although real estate cap rates have yet to follow bond rates higher, many believe this is what’s in store for the market. Rising interest rates will likely trigger higher cap rates.
However, it remains to be seen whether a rise in cap rates will signal a subsequent drop in real estate prices, or whether fundamentals will remain strong enough amid an improving economy that properties could maintain current pricing levels, or even see a further rise in prices.
What does that mean for residential real estate investors? If you are buying residential real estate for cash flow, the level of interest rates determines the ROI and the price you will offer. If you can get 6% in the bond market, without doing any work, you need at least that return if you own/buy real estate.
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