How Fed Policy Distorted the Commercial Real Estate Industry

Underpinning this activity in commercial real estate is an audience of average Americans who have been trained to believe that asset prices only go up...

The analysis and discussion below pertain to the entire commercial real estate industry, but I will use the multifamily sector as the specific case to which the general rule applies.

The multifamily sector comprises the development and/or operation of multi-unit residential housing, generally known as apartments but also comprising various subcategories therein.

Participants in the multifamily industry include developers, who acquire land and build new apartment units; investment sponsors, who raise capital to buy apartments for investment purposes; operators, who execute the day-to-day tasks of apartment maintenance and management; and a bevy of related service providers, administrative bodies, and others.

In a standard context, evaluation of this market is fairly straightforward. In order to succeed, developers must choose a suitable location and build a product to the highest level of quality that their constraints – including budget and catchment area – allow. Any less would negatively impact their sales process and subject them to reputational injury, limiting their future ability to borrow, build, and sell again.

Investment sponsors must exercise shrewd judgement in the acquisition of properties that provide both attractive valuation and opportunities for growth. Failing this, raising future capital would prove remarkably difficult, as investors would be wary of repeat failures and ultimately come to avoid those sponsors who showed an inability or unwillingness to exercise keen judgement.

Apartment operators must carefully balance cost and quality, aiming to find the right balance between maximizing profitability and cash flow while serving the needs of tenants. This is easier said than done, as short-term expenditures that reduce cash flow temporarily may bolster long-term profitability prospects. Knowing how and when to make these tradeoffs requires critical reasoning and a long-term outlook.

The Policy is Poison

Stated mandates aside, the Federal Reserve exists to enable the federal government to pay its increasingly gargantuan bills. In order to accomplish this task, it resorts to a few devices.

Setting artificially low interest rates attempts to forcefully depress the cost of government debt, taking the critical function of pricing away from the market and putting it in the hands of bureaucrats with powerful computers. When the Fed “cuts interest rates,” one of the things it actually does is print money digitally and acquire government securities. This sets off a chain of events that increases liquidity in the banking system – that is, the supply of money. This greater supply ostensibly entails lower “prices” in the form of lower interest rates.

But artificially low interest rates – and, critically, the expectation of same in the future – has the effect of driving up asset prices. As low interest rates permeate the economy, near-term cash flows are discounted by a lower cost of capital, leading to higher valuations across all asset classes. Currently low interest rates are bolstered by a Federal Reserve and federal government jawboning future interest rates lower. This has the effect of sustaining low discount rates further along a respective investment’s time horizon, thus inflating terminal values and therefore asset prices.

This is especially salient in the commercial real estate industry, which is heavily dependent on debt capital. As interest rates are lowered, asset prices go higher and, in so doing, expected returns are lowered.

How Participants Respond

In an environment of forever artificially low interest rates leading to high prices and low expected returns, investment sponsors have a choice.

On one hand, they can communicate to their investors the state of affairs as it is. This would naturally lead to lower transaction volumes, as low return opportunities were shunned. This would entail those sponsors earning less transaction fees, but it would essentially signal the market that prices were too high, and thus set in motion a correction.

On the other hand, sponsors can ignore reality and advertise higher returns than the market offers by making unrealistic operating assumptions regarding their prospective investments and convincing the investment public – institutional and everyday investors – that those assumptions are valid.

This is generally done by back-ending the profitability of prospective investments. For example, if an unscrupulous sponsor wishes to convince others that his upcoming project generates a 20% Internal Rate of Return despite earning cash yields of only 4-5% during the early stages of the investment period, he can simply project that the asset price will appreciate at a rapid pace over time. This is done primarily through cap rate compression, an expectation that investors will continue paying higher and higher prices for the same level of profitability. In the stock market, this phenomenon is known as multiple expansion. Whatever you call it, it’s a symptom of a market where fundamentals have been ravaged in favor of speculative mania.

This attribution of most of a project’s projected returns to an unknowable factor – the price of the asset at the end of the hold period – would typically be scoffed at by knowledgeable investors, but those no longer exist in any meaningful sense. Investors with cash continuously being debased by price inflation find it impossible to resist the lure of promised returns no matter how absurd the assumptions behind them. This dynamic is exacerbated by a dearth of investment options elsewhere that offer a suitable risk-return profile. And so, the cycle carries on, transferring wealth from investors with low information to sponsors with low character and ability.

Real estate developers, for their part, are compelled to cut costs and quality in an era when most aspects of real estate development cost twice as much as they did just five or six years ago. Knowing they will have a pool of buyers regardless of what they produce, the result is unattractive buildings, shoddy workmanship, and a product that sells at a high price but requires inordinately high upkeep costs to compensate for the poor build quality.

Both developers and sponsors benefit from Fed policy of excess liquidity combined with artificially low interest rates. Lacking this liquidity, lenders would be far more discerning regarding to whom – and for what purpose – they lent their money. But the money was printed and injected into the banking system. Therefore, it must be lent.

Multifamily operators – property managers – are in an especially difficult position. While they may benefit tangentially from artificially low interest rates and high liquidity in the capital markets, they must deal with the reality of apartment operations each day – a reality that can’t be escaped even in a perma-bubble environment. To wit, tenants are not seeing wage increases on par with asset prices or operating expenses. The main source of apartment rental revenue is therefore getting weaker while everything that comprises apartment expenses is getting more expensive. Reconciling these two facts while delivering high profitability and keeping high standards of maintenance and cleanliness at the level of the physical plant is an impossible task.

Underpinning this activity in commercial real estate is an audience of average Americans who have been trained to believe that asset prices only go up, not fully understanding that asset price inflation simply represents a unit of measurement – the US dollar – that is being relentlessly debased by an unsustainable Fed policy.