Dow plunged 666 points on Friday, yet the jobs report was strong. Why the selloff? Why are treasury rates on a tear? Why did mortgage rates also jump? What does this mean for real estate? Are certain real estate sectors more impacted than others?
The Dow industrial average lost 5% of its value in one day. Why? The jobs report came out Friday and “spooked” the market. It showed that wages were finally starting to pick up and therefore inflation would also likely pick up. This led to a selloff in treasuries as yields increased to price in the “inflation risk”. At the same time there is uncertainty on the new direction of the federal reserve. Janet Yellen gave up the reins to Powell and the market began questioning 3 vs 4 rate hikes this year.
The market is at all time highs with valuations far above historical averages. The markets are therefore “jumpy”; to justify the current valuations the economy and corporate earnings must perform flawlessly. The markets have also have had an extremely long period of growth and there are fears that we are near the end of the current cycle.
Is this a blip or a trend?
There have been debates on whether this large drop is the beginning of a trend or just the market taking a small “breather”. Regardless of whether this is a trend or blip, the large drop was a meaningful reminder of risk presently in the market. This market risk will lead to increased volatility going forward.
What about real estate?
Real estate is closely intertwined with the stock market. There are three key pieces that link the stock market with the real estate market. These three variables are rates, consumer sentiment, and fund reactions
Rates: As longer-term treasury rates increase, the cost of borrowing increases for residential and commercial property owners. The increase in rates changes the dynamics of what buyers can afford and the rate of return on their investment for income properties. As rates increase, the real estate market will slow as liquidity is decreased.
Consumer sentiment: How consumers react is difficult to predict. If there are large market swings, consumers become less confident and are less willing to make a big financial commitment. They are also more likely to desire liquidity in times of uncertainty
Fund reactions: The real estate market is a global game now. Billions in real estate is managed by large funds dispersed throughout the world. In times of volatility they might begin to pare holdings in certain markets to reduce risk. Large funds are “market movers” in buying and selling properties. As the market increases volatility, many funds will likely sit on the sidelines building up liquidity to take advantage of future market opportunities.
Is certain real estate riskier due to the market swings?
Although all real estate will be impacted by higher rates, consumer sentiment, and how real estate funds react. There are two areas that are more prone to disruption from the market swings. These are high end residential real estate and lower return (lower cap rates) commercial properties.
High End Residential: The high end residential is more prone to disruption from stock market gyrations. The group able to afford high end real estate is heavily invested in the market and therefore more likely to pull back due to sudden shifts. For example think of the buyer of a ten million dollar second home in Aspen. This buyer is significantly invested in the stock market. Assume they had 10 million in the market they were going to sell to purchase the property in Aspen. Based on the recent dip, they could have lost five percent so now they have 9.5 million to buy a property. The very high end is also driven by consumer sentiment and a desire for liquidity. They are typically the first to pull back before a major market change.
Low return properties: With the recent run up in property values throughout the country there has been an insatiable appetite for stable investments. This large price increase has reduced the returns on many properties. In commercial real estate the rate of return is called the Capitalization Rate. The Cap rate on many properties is at historical lows. For example an apartment complex in Denver recently traded at a 2.5 cap. This means the property after expenses will return 2.5% to the owners. As treasuries rise above this rate why would someone invest in an apartment for a 2.5% rate of return when they could go buy a treasury note with a 3% return (it was 2.8% last week and predicted to hit 3% shortly). Why is this important? If investors demand a higher rate of return (cap rate) then prices of low cap rate properties will decrease (or not be able to be sold).
What should you do?
If you need to sell/restructure in the next three years, now is the time to act. There is still considerable demand for good properties. This window is quickly closing at the end of our current financial cycle. If you have a longer-term horizon then be ready to sit tight and “ride” the market. The next exit opportunity could be years away.
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all they need is their simple one page application (no upfront fees or other games).