What macro forces most strongly shape real estate market performance and how should investors track them?
Real estate market performance is primarily driven by interest rates, employment concentration, and credit availability rather than the local micro-market factors most investors focus on. Investors who systematically track macro indicators are better positioned to anticipate price moves than those who rely on current inventory and transaction comps.
1. Interest rate levels are the single most powerful macro force determining real estate cap rates and therefore asset values. 2. Employment concentration and income level trends in a market are more reliable predictors of sustained price appreciation than current inventory levels. 3. Credit availability for real estate buyers is a leading indicator of demand that typically moves 6-12 months ahead of visible price changes. 4. Investors who track macro forces systematically consistently outperform those relying on local micro-market observation alone.
Cap rates have been declining nearly 7.45% per year since 1984, from 12.02% to 3.63% in 2015, and Chatsworth has been seeing lower as the firm negotiates M&A transactions for clients. Average price per square foot prices have been growing at a compound annual rate of 11.925% from Q4 2010 to Q4 2015, or a gross rate of 75.644% over five years. 52% of current residential developments are for $5M+ units, followed by $1M to $2M units accounting for 15.6% of new development.
Real estate prices always go up. It is a statement that is conditionally correct, as long as your economy is driven by inflation. But inflation is really just a way of saying: we are expanding the money supply. As inflation rises, hard assets like real estate, which are linked to inflation, go up. But dig deeper and we see that there is more to this than inflation alone.
The Correlation Between Rates and Real Estate
When we buy real estate we usually look for a mortgage, or big companies take out debt. Fed Funds rates impact U.S. Treasuries, mortgages, the cost of debt, and in turn capitalization rates. Capitalization rates, or cap rates, represent the yield a building provides to its investor. Over a 30-year historical period, rates, Treasury yields, and cap rates are all correlated, trending down at around 7.21% per year, while condo prices are trending up at nearly the same rate of 6.91%.
This decline in rates encourages developers to build and buyers to buy. As money becomes cheaper, companies can take on greater risk, buyers can afford higher prices, and we see a real estate development boom. The inverse relationship between yields and price means that as mortgage rates drop, the price per square foot and the price of buildings increases.
The 2012 Inflection Point
With rates at 0% since 2009, the 10-year Treasury yield in mid-2012 dropped from around 3.4% to 1.9%. The average price per square foot went from $1,530 to $2,271, a 48.4% drop in yield driving a parallel increase in prices. This move brought the recent increase in condo prices, office space, and retail rents. Cap rates for rental buildings compressed further. From our own experience, we are seeing prices fall below the 2.5% cap rate in many cases, bringing us to the realm of negative leverage ratios, where the cost of debt is higher than the returns.
The future of the market will depend on various factors, but with the Fed trying to raise rates, we have to wait and see if any major movement will happen. Negative rates would only cause real estate prices to go higher as cap rate compression continues. If the market does reverse, real estate prices will take time to adjust and investors will have to view their real estate returns from a total return perspective.
The real estate market is shaped by macro forces including interest rates, employment trends, and credit availability that most buyers and investors underweight relative to micro factors like property condition and local amenity when making allocation decisions.
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