Risk Premiums and Low Cap Rates Imagine yourself on ”Let’s Make a Deal!” facing three choices. Door Number One hides either $20,000, or free dinner at Burger Doodle. Door Number Two will either reveal $20,000 or a sack of peanuts. And for your third choice, Monty is holding $10,000 in hard cash. If you forego the certainty of the cash and choose either door, you are taking a known risk (a 50-50 chance of getting $20,000) for a known price ($10,000 in cash). If you choose either door even after Monty ups the cash to $18,000, you may have what it takes to become a real estate investor. In this article we propose that investors are taking unsupportable risks by paying more for income property than can be supported in the long term. We illustrate this by showing that at present cap rates, investors are actually getting negative returns for risk. In essence, today’s buyers are choosing Door Number Two even after Monty offers $20,330! Let’s split cap rates into their major components. There is the recapture and return on capital to the lender. There is the recapture of the investor’s equity. And there is the return the investor demands for tying up the equity. This return to the investor is the most variable part of the cap rate—one investment opportunity competes with other kinds of investment, and risks in one type investment will affect investor appetite for that investment. Over the past 15 years or so, real estate risk has fallen between the stock market (higher risk) and investment grade bonds (lower risk). The “risk premium” is the extra return investors demand from any specific investment to entice them to forego a safe investment like Treasury bills. Recent high real estate market values (and low cap rates) show that real estate is experiencing shrunken risk premiums. The "cap rate,"--the net rental income divided by the market price--is at an all-time low. For multifamily it stands at 5.5% to 6% (and lower in some hot markets) compared to an historical average of 8% to 10%. The point of this article is that these prices don't reflect the true risk of real estate ownership. One way to estimate the risk premium is to compare cap rates to the return on a very safe instrument, like the ten-year Treasury. The ten-year Treasury currently trades in the 4.5% to 5.0% range, so we’ll take 4.75% as our example. To get the “real interest rate”, we have to subtract the part of that 4.75% that reflects inflation expectations. The CPI has averaged around 2.5% annual increase for the last 20 years—so let’s say 4.75% Treasury yield minus 2.5% inflation gives a “real interest rate” of 2.25% on the Treasury. To get from this to the risk premium, we take today’s cap rate and subtract the real interest rate. A cap rate of 6.0% minus the real interest rate of 2.25% put today's real estate risk premium at 3.75%. Is that a reasonable risk premium? Let’s look at a typical financing situation where the buyer is putting 20% equity into the deal and borrowing 80% for 20 years at 5% annual interest paid monthly. For this exercise, let’s stick with our typical cap rate of 6%. The lender gets a return on the financing; the investor gets a return on the equity; the cap rate is the weighted average of the two, as in this formula: Lender’s Return X 80% + Derived Equity Return X 20% Actual Cap Rate Solving for the Derived Equity Return, we get: Derived Equity Return = (Actual Cap Rate- Lender’s Return X 80%) / 20% The lender’s return is the mortgage constant (the payment amount on a loan of $1). In our hypothetical, this is 0.079194689. Derived Equity Return = (.06- 0.079194689 X 0.80) / 0.20 Derived Equity Return = - 1.67% That is correct—the investor has a negative return. How is this possible? Let’s assume our investor has a five-year investment plan. He is taking one or both of two serious gambles-- (a) net income will rise during the five-year period, and/or (b) the sale price at the end of five years will be high enough to wipe out any losses. But is this rational? Historical cap rates have always included investor expectations of rental increases and terminal resale, so today’s low cap rates rest on the belief that for some reason, future performance will be far, far better than past performance. Yet in most locations, developers are having a hard time projecting rental increases that exceed inflation. The math is absolute—if there are not increases in rental income, then there must be even lower cap rates in order to recapture losses at the exit. But since current cap rates already have negative returns for the investor, five years from now our property owner is going to have to find someone with even rosier beliefs about rental increases. Some have suggested that cap rates can be this low because investors no longer look at cap rates, and focus instead on the internal rate of return (IRR). . While IRR has become a more widely used measure, I disagree. Cap rates reflect behavior more than they predict behavior. An overall cap rate (OAR) incorporates all elements of investor expectations, no matter whether based on a pro forma or the secret family recipe for success. Others have proposed that investors are looking not only at NOI but rather at the overall tax advantages available in real estate. I have ignored “tax advantages” because there have not been serious changes in the tax position of real estate investment since the 1986 reforms. Thus cap rates have long reflected today’s tax advantages, and the drop in cap rates is not greatly influenced by tax considerations. Instead, I conclude that current property values indicate that investors are over-estimating future income and future sale prices for rental property. By underestimating the risk of real estate ownership relative to other investments, investors are accepting increasingly low compensation for risk. And as Alan Greenspan has so gently put it, “History has not dealt kindly with the aftermath of low risk premiums."
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