Everything You Need to Know About Interest Rates

What Are Interest Rates?

The Federal Reserve’s Policy Committee (FOMC) sets a desired range for inflation between 1.7%-2%. The FOMC monitors inflation using the Consumer Price Index (CPI), which measures the average change over time in prices that consumers pay for a certain basket of goods and services.

The Federal Reserve’s job is to manage the economy, so that we don’t have too much inflation and ensure that there is no deflation. Both would be very bad for our day to day lives. The Federal Funds Rate is used by the Fed to manage this tightrope walk. The Federal Funds rate is the interest rate that depository institutions (banks and credit unions) use to lend reserve balances to other depository institutions on an overnight, uncollateralized basis.

When the Fed sees that inflation is beginning to increase, they raise the Federal Funds rate to slow down the economy and prevent it from overheating. When they see deflation beginning, they decrease the rate to spur economic growth. There are other factors in play, but this is a 10K foot description.

In December 2008, the Fed lowered the Federal Funds rate to 0.25% (which is effectively 0%), due to the Great Recession, and kept the rate at 0% until 2015, even though the recession technically ended in June 2009. In Dec 2015, economic growth seemed to stabilize, and the Fed began to increase the Federal Funds rate. From December 2015 to December 2018, the Federal Funds rate increased from 0.25% to 2.5%. Compared to the past 62 years, the rate of 2.5% is still extremely low. The long-term average is 4.79%.

The Federal Funds rate is the Fed’s main tool to combat a recession. In 2006, the Federal Funds rate was 5.25%, and within 30 months, in December 2008, the Fed had reduced it to 0.25%. Central Banks in other countries use the same tools for their own economies. This story played out similarly throughout the world to try and pull economies out of the recession. Today (September 9th, 2019) the Federal Funds rate is 2.25%, with another expected drop coming any day now.

The United States is in the middle of the pack as far as Central Bank interest rates go. Some countries (Switzerland, Denmark, Sweden, and Japan) have negative bank rates, meaning that they give you less money back than you give them. The Eurozone and UK are essentially at 0%, and many other developed countries (Australia, South Korea, Canada, etc.) are not much higher. Click here to see the full list. Argentina is going through some serious economic issues right now, and their target interest rate is 58%.

Why Does This Matter?

Trouble arises when an economy goes into a recession while interest rates are low. Central Banks use interest rates as a tool to prevent recessions, but if interest rates are low when the recession hits, the Central Bank doesn’t have much room to reduce them. Reducing interest rates further doesn’t have much impact on the economy, leaving the Central Bank without a tool to pull the economy out a recession. In that case, you can get deflation, which can lead to serious civil unrest.

Focusing on the US, the current unemployment rate is 3.7% and the stock market is at a near all-time high. The general thought is that the economy is somewhat strong, but since the Fed isn’t seeing inflation, they’re likely to keep cutting rates.

This is where things get interesting. The Federal Funds rate is connected indirectly to US Treasuries. US Treasuries are bonds that the US government issues and guarantees, in order to fund deficits in their operations (military, healthcare, etc.). The rate of US Treasuries is based on the Federal Funds rate, duration of bonds, and supply/demand for the bonds. Even if the Federal Funds rate is at 0.5%, a 10- year Treasury could have a rate of 3%, because of the other factors in play.

Today, the 10-year US Treasury is ~1.62%, which is below the Federal Funds rate (2.25%), and below the 3-month US Treasury at ~2.06%. When long-term Treasury rates are lower than short-term Treasury rates, it’s referred to as the inversion of the yield curve. It’s a signal that we’re either about to enter a recession or are already in a recession. But this signal contradicts those from other factors in the economy, like employment, stock market, asset values, etc.

This all relates to real estate investing, because US Treasuries are the basis that banks use to calculate their interest rates. Low interest rates lead to low cap rates, which result in high property valuations. Buying a property where the rents are $700 and increasing them to $1,000 is a win if the going-in cap rate is 6% and the going out is 6%. It’s a loss if going in is 6% and going out is 9%, and a home run if the going out is 4%.

Why Are Interest Rates So Low?

The historical belief is that rates will go up. When I started in 2009, everyone told me to fix my interest rates because they’re going to go up. If I had a dollar for every story that I heard about the 1980s and double-digit interest rates, I’d be a rich man. Well, they didn’t go up. In fact, they went way down.

This is for a few reasons. The biggest is China. China is the largest foreign buyer of US Treasuries, and they control over a $1 trillion in US Treasuries (Japan also controls over $1 trillion). China is interested in keeping Treasury yields low, so they can sell their products in the US. If there is a recession in the US, then there will be one in China as well, because their export market will dry up significantly.

The other issue is that the US government runs a deficit, meaning that they need to sell Treasuries (i.e. borrow money) in order to stay in business. Right now, the deficit is nearly $1 trillion per year. A lot of this deficit is due to tax breaks that President Trump provided to individuals and corporations. His theory is that growing the economy (hiring and investment) will result in more taxes, so reducing the rates is a wash over time. In addition to the current deficit, the US government has future obligations and demographic trends that will only raise the cost of operating even higher. These trends will come into effect as baby boomers get on social security and Medicare. So, the US government is somewhat motivated to keep their borrowing cost low.

A little movement on the interest rates can change our cash-on-cash return from 4% to 6%. Think about the effect that these rates have on trillions of dollars. If there’s no inflation, then the US government would be paying the debt back without growth and would need to sell assets to do so. This would not be a pretty picture for anyone. We’ve seen examples of this in other countries.

How Long Will Interest Rates Be This Low?

This is the trillion-dollar question. I’ve made the case as to why they’re low, but I’m not sure what gets them to go back up. If we experience incredible economic growth, that would lead to inflation and our ability to repay the debt faster. Given the Federal Reserve’s outlook of low rates, it doesn’t seem like that growth is around the corner.

The biggest factor that would increase rates is if US Treasuries became less attractive for investors. If there was a safer place to put your money or if the US guarantee became less valuable, then Treasury rates would certainly increase. Again, I don’t see this on the horizon. Just looking at the list of current interest rates around the world, it seems the US is somewhat in the middle of the pack and still has a pristine reputation of paying on time.

What Are the Takeaways?

A key takeaway for me is that fixing the interest rate is not always the solution. In fact, sometimes it makes a lot more money and sense to float. We own a large property in Houston (800+ units) that has mortgage of about $40M. In 2013, we took out a 10-year loan against it at around 4.9%.

Since then, we’ve captured a lot of value. Rents increased by $300, cap rates decreased from 6% to 4.5%, and the NOI is up over $1.5M since the acquisition. Based on the current NOI and lower cap rate, the value is up at least $33M in the past 6 years. At the same time interest rates have dropped and today we could likely finance the asset for 3.5% fixed for 10 years with interest-only for the entire period. Our current loan at 4.9% is amortizing. Every 100 basis-points in interest rate cost us roughly $400K in debt service. Therefore we’d be saving roughly $600K per year in debt service before the cash flow differences from amortizing versus interest only.

Had we decided to use a floating rate option, we could have captured that value appreciation and refinanced to return all the equity when the business plan is complete. Instead, today, our equity is locked up, because it would cost millions to prepay the in-place loan. Most loan prepayments are based on yield maintenance, which means that the lender will only let you prepay if you also pay the yield that they’d be missing by forgoing the future payments. If interest rates are higher today then when you locked in, it’s relatively inexpensive. If not, then it’s very expensive.

Of course, I’m coming to all these realizations when interest rates are extremely low. There’s a very solid argument to fix today (given the inverted yield curve) instead of choosing a floating rate option. Fixed-rate debt protects against future rate increases; however, fixing does limit options significantly. As described above, future interest rates are impossible to predict.

Most floating-rate solutions require a cap, which can be tied to the yield curve of specific Treasury durations. In instances where the rate goes above the projected yield curve, the investor is covered. When it’s below the yield curve, we get paid the difference. On a property that we sold this year, this actually happened, and it more than paid for the fee to put the cap in place.

We believe that having some flexibility is valuable. It’s hard to put a value on that flexibility. Given the cost of prepaying loans, it can be millions of dollars. Moving forward, we’re going to continue looking at both fixed and floating options.

Underwriting Consequences

When analyzing a real estate investment, an important component is the going-in cap rate and anticipated going-out cap rate. I’ve mentioned in previous newsletters that we think of going-in cap rate as:

Purchase price [divided by] trailing 3-month income [minus] Year 1 pro-forma expenses (tax adjusted)

In our opinion, this cap rate is the basis for a property’s current value. A common underwriting practice is to expand the cap rate out by 10 bps every year until sale. For instance, if the going-in cap rate is 5%, then in 5 years, you’d expect to sell at a 5.5% cap rate (tax adjusted).

In reality, this has been an overly cautious underwriting practice that’s held us back when buying more properties. The 6% going-in cap rate from 2014 is now selling for 4.25% (or even less).

I don’t subscribe to this idea that cap rates will forever fall, nor do I think that it’s a safe way to analyze opportunities. That being said, a lot of deals today do not work as planned (i.e. rents and income don’t grow as expected), yet the sponsors are still showing good returns due to cap rate compression instead of expansion. This is especially visible in the Class B and C space, which is why we’re net sellers in these property types.