I recently listened to a fantastic conversation between a couple of thought leaders in the value investing space that I really admire. Howard Marks and Joel Greenblatt have been investing for a combined total of 90 years and provide a wealth of knowledge and perspective. In an interview on Real Vision Finance, they walked through their views on various topics we've been pondering for years: the situation with interest rates, valuations, and their own investment principles to stay focused in today's market environment. Below are my thoughts as it relates to one of my circles of competence: real estate investment.
I've had a really hard time coming to grips with the market's belief that the historically low interest rate environment we've experienced since the 2008-2009 financial crisis is here to stay. Interest rates (along with aggressively supportive FED actions) are perhaps the leading driver behind today's high real estate asset price valuations.
But are these near-zero levels and endless asset purchases by the FED to support the market really going to be permanent? This conflicts with the long-term view of mean-reversion: the concept that metrics such as interest rates may move to extreme positions over certain time periods, but over the long-term, they ultimately work their way back to the long-term average. So what happens to values when rates go back to "normal"? The long-term average FED funds rate (from 1954 to today) is 4.7%; from 2008 to present, the average has been 0.65%. Actual borrowing rates are a bit higher than this depending on the characteristics of the asset being purchased and the borrower.
Let's take a multifamily investment property as a practical example. If this property qualifies for agency financing with a 3% rate, that equates to a mortgage constant (borrowing cost that incorporates interest and principal amortization) well above 5% today. If rates "normalized" to 5%, the borrowing cost would be about 7%. Are future buyers really going to pay aggressive cap rates below this level on this property given those borrowing costs?
If the property doesn't qualify for agency financing or you're pursing a different type of investment, rates would be higher, and the implied returns to a future buyer (your exit option) would be correspondingly lower.
I fundamentally believe that value is a function of cash flow. So the only way an excessively high valuation today is rational to me is if there is enough upside in the asset that can reasonably be extracted during your holding period to meet your total return requirements WHILE offsetting any value "lost" due to mean-reversion in interest rates. For real estate investments, we factor this in as a higher ("normalized") cap rate on exit. It's certainly doable, but it takes a lot of screening and quite a lot of hard work to do!
Ludwig Diaz
Managing Principal
Starlifter Capital
I've had a really hard time coming to grips with the market's belief that the historically low interest rate environment we've experienced since the 2008-2009 financial crisis is here to stay. Interest rates (along with aggressively supportive FED actions) are perhaps the leading driver behind today's high real estate asset price valuations.
But are these near-zero levels and endless asset purchases by the FED to support the market really going to be permanent? This conflicts with the long-term view of mean-reversion: the concept that metrics such as interest rates may move to extreme positions over certain time periods, but over the long-term, they ultimately work their way back to the long-term average. So what happens to values when rates go back to "normal"? The long-term average FED funds rate (from 1954 to today) is 4.7%; from 2008 to present, the average has been 0.65%. Actual borrowing rates are a bit higher than this depending on the characteristics of the asset being purchased and the borrower.
Let's take a multifamily investment property as a practical example. If this property qualifies for agency financing with a 3% rate, that equates to a mortgage constant (borrowing cost that incorporates interest and principal amortization) well above 5% today. If rates "normalized" to 5%, the borrowing cost would be about 7%. Are future buyers really going to pay aggressive cap rates below this level on this property given those borrowing costs?
If the property doesn't qualify for agency financing or you're pursing a different type of investment, rates would be higher, and the implied returns to a future buyer (your exit option) would be correspondingly lower.
I fundamentally believe that value is a function of cash flow. So the only way an excessively high valuation today is rational to me is if there is enough upside in the asset that can reasonably be extracted during your holding period to meet your total return requirements WHILE offsetting any value "lost" due to mean-reversion in interest rates. For real estate investments, we factor this in as a higher ("normalized") cap rate on exit. It's certainly doable, but it takes a lot of screening and quite a lot of hard work to do!
Ludwig Diaz
Managing Principal
Starlifter Capital