Stocks Tank! Is Real Estate Next?

The Dow plunged 666 points last Friday and 1,100 points yesterday, but the jobs report remained strong, and we are left with several questions:

Why the selloff?

Why are Treasury rates on a tear?

Why did mortgage rates jump as well?

What does this mean for real estate?

Are certain industry sectors more impacted than others? 

WHAT HAPPENED?

The Dow industrial average lost 5 percent of its value in a single day.

Why?

The jobs report published Friday seemed to spook the market. It showed that wages were finally beginning to pick up and therefore inflation would likely follow suit. This led to a selloff in Treasuries as yields increased to price in the inflation risk. Simultaneously, there is uncertainty for the new direction of the Federal Reserve. Janet Yellen gave up the reins to Jerome Powell as the Fed chair person and the market began questioning three versus four rate hikes this year.

WHY NOW?

The market is at all-time highs with valuations far exceeding historical averages. The markets are therefore jumpy to justify the current valuations the economy and corporate earnings must perform flawlessly. The markets have also had a 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 drop is the beginning of the end or just the market taking a small breather. Regardless, the dip 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 decreases. 

CONSUMER SENTIMENT

How consumers react is difficult to predict. If there are major market swings, consumers become less confident and are less willing to make a 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 risks. 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 market is 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 $10 million second home in Aspen, Colo. This buyer is significantly invested in the stock market. Assume she had $10 million in the market she was going to sell to purchase the property. Based on the recent dip, she could have lost 5 percent, so now be left with only $9.5 million. The high-end market is also driven by consumer sentiment and a desire for liquidity. These buyers are typically the first to pull back before a 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 price increase reduced the returned 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 percent to the owners. As Treasuries rise above this rate, why would someone invest in an apartment for a 2.5 percent rate of return when they could go buy a Treasury note with a 3 percent return (it was 2.8 percent last week and predicted to hit 3 percent 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 or 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 opportunity could be years away.