Risk Spread Premium
I just read a short article from a real estate guru. He was talking about the “Risk Spread Premium” on real estate Capitalization (CAP) Rates compared to the 10-year US Treasury bond.
His basic assertion is to compare the difference (spread) between the average CAP rate of income properties to the yield on the bond. The greater the spread means the better investment for income properties, because the inverse logic means that it’s safer to invest in bonds compared to real estate when the spread is small. US Treasury bonds are very safe, so why take the risk on income property when the difference in yield is small?
Here are some fallacies in that logic:
I don’t invest in bonds, especially US Treasury bonds, mostly because I don’t like the idea of the US debasing its currency with the printing press. Losing purchasing power through debasement is a bad investment.
Interest rates are at ridiculously low rates, below the rate of actual inflation. That’s never a good time to invest in bonds, especially when combined with debasement. The only direction for interest rates is up, which means declining bond prices. Losing principal value compounds the loss on top of lost purchasing power.
Income property can respond to inflation through higher rents according to what the market can bear. That provides strong management control over your investment compared with no control over bond prices.
The power of leveraging “Other People’s Money” (OPM) for structured financing of income property far outweighs the alleged safety of government bonds.
The capitalization rate is meaningless until it is calculated in the presence of structured financing with debt and equity. Real estate is a “borrowed money” business that provides leverage. The actual CAP rate for an income property is determined from the cost and structure of its financing.
Investors look to the “Cash on Cash Return” (CCR) to determine whether the LEVERAGE on their debt and equity adequately compensates them for their risk. However, most real estate investors don’t know the relationship between CAP, CCR, and the cost and structure of financing. By the way, I call the CCR the “Gross Return on Equity” (ROE), because equity can be acquired in other ways than just cash invested as a down payment.
For the above reasons, there is really no logical comparison between government bond yields and investing in income properties. It’s like comparing apples and oranges.
Net Operating Income: NOI (income minus expense)
Debt Present Value: DPV (the original total debt)
Annual Debt Constant: ADC (original debt annual cost)
Annual Debt Service: ADS = ADC × DPV
Loan to Value: LTV (combined senior tranches)
Equity to Value: ETV = 1 – LTV
Leverage to Price: LTP = LTV ÷ ETV
Debt Coverage Ratio: DCR = NOI ÷ ADS
Debt Coverage Margin: DCM = 1 ÷ DCR
Cash Flow Margin: CFM = 1 – DCM
Gross Return on Equity: ROE = (DCR – 1) × ADC × LTP
Debt Coverage Ratio: DCR = 1 + (ROE ÷ (ADC × LTP))
Capitalization Rate: CAP = DCR × ADC × LTV
Maximum Allowed Offer: MAO = NOI ÷ CAP = DPV ÷ LTV
Leverage to Yield: LTY = ROE ÷ CAP = CFM ÷ ETV
Cash Flow Before Tax: CFBT = ROE × ETV × MAO
Net Operating Income: NOI = CFBT ÷ CFM = MAO × CAP
The CAP rate depends entirely on the DCR, ADC, and LTV, as does the ROE (CCR) rate. The value of income property depends on calculating a capitalization rate on the cash flow relative to the cost and structure of the financing (debt and equity). These values are controllable and manageable, unlike US Treasury bond prices and the US Mint printing press (controlled by the Federal Reserve Bank).
So called “Comparable CAP Rates” are meaningless, because an investor can’t know the cost and structure of the financing applied to the comparable properties, and cannot recreate that financing structure for the subject property. The investor can only know what cost and structure is available for the subject property at the time of purchasing or refinancing that property.
This is why property values fluctuate according to the availability of financing. In general, financing is always available, and the real question is “what is the cost of that financing?” We’ve all seen property prices fall in times of tight liquidity, which means that high cost financing reduces the property value and vice versa. The “mortgage meltdown” was caused by rapid price inflation due to the availability of low cost high leverage financing. Trying to use comparable CAP rates to justify an inflated price is simply looking for a greater fool. Sophisticated investors understand how to use the equations to calculate the correct offer price according to the cost and structure of the financing that is available to that investor.
In my humble opinion, using prudent judgment and skill to invest in income property with proper levels of debt and equity is much safer and produces higher yields compared to government bonds, regardless of the spread in interest rates.