Interest rates.

Is there a more boring subject than interest rates?

Likely not.

Yet the interest rate (the “price of money”) is the most important number in financial markets.

And right now, that number – in relation to commercial real estate – is causing a whole bunch of fuss.

As the Wall Street Journal recently reported:

The troubled commercial real estate market is bracing for a record amount of maturing loans, boosting the prospect of a surge in defaults as property owners are forced to refinance at higher rates.

Oh dear!

Yes, refinancing is a big deal. But when looking at it, most comments and analyses tend to look at it from the borrower’s side.

Arguably, the better way to understand the problem is from the lender’s side. We’ll do that today below. But first, we’ll check in on today’s market action…

Market Data

The S&P 500 closed down 0.5% to end the day at 5,005.57… the NASDAQ fell 0.8% to close at 15,775.65.

In commodities, West Texas Intermediate crude oil trades at $79.17, up 99 cents…

Gold is $2,024 per troy ounce, up $9…

And bitcoin is $51,884, up $108 since yesterday.

And now, back to our story…

Think About It From the Lender’s Side

So, what’s the difference in looking at it from the lending side, rather than the borrowing side?

Quite simple. When you look at it from the lending side, you’re looking at it from the investor’s point of view.

That allows us to draw easier parallels with stock investing, and the emotions and decision-making you likely go through as an investor.

Think back to much of the last two years.

What was the big story in stocks?

It was valuations and the impact of rising interest rates on stock prices.

Commentators and analysts – our Legacy Research experts included – noted how investors had a choice.

They could invest in growth stocks… which typically don’t like rising interest rates… or in dividend stocks… but dividend stocks are also at risk of falling based on future interest rate forecasts.

That’s where we get the comparison to those lending to commercial real estate.

Just as a stock investor may not want to risk a 4%, 5%, or 6% dividend yield on a stock when they could get 5% on a CD (certificate of deposit) or a bond…

So an investor lending to a property developer or real estate investor may not want to lend at a 5% or 6% yield when they too can get a similar risk-free yield from government bonds.

On top of that, remember the real estate lender has a different risk… a big risk they may not want. Especially in a market like this.

Remember that if the real estate investor (the side borrowing the money to buy the property) defaults on repaying the bondholders, the bondholders may ultimately end up taking possession of the property.

Would they want that?

Would they really want to take possession and then deal with everything that involves? Most of what real estate investors refer to as the “3-Ts”: Toilets, Trash, and Taxes.

You can add a fourth T to that: Tenants.

We don’t think they want that. They just want to “clip the coupon,” take their money, and move on to the next deal.

So, in our view, that’s the biggest issue with the commercial real estate problem. It’s not just about the ability (or inability) of borrowers to repay.

It’s just as much about – if not more so – the willingness of lenders to lend.

To illustrate the potential problem, check out the chart below from Bloomberg.

It compares the 10-year U.S. government bond yield with the “cap rates” on office space in Silicon Valley and the spread between those two rates:


Source: Bloomberg

By the way, the “cap rate” is short for capitalization rate. According to real estate analyst, Brad Thomas in his best-selling book “REITs for Dummies”…

[The cap rate is] calculated by dividing a property’s or portfolio’s net operating income in the first full year of ownership by its purchase price. It is used to estimate the investor’s potential return on their investment in the real estate market.

What this serves to show you is the gap (spread) between cap rates and bond yields is trending lower. The fact it’s doing so in the economically sensitive Silicon Valley area is important.

Look along the dateline on the chart. Leading up to big economic busts, the spread shrinks. That makes total sense. It shows investor sentiment. As rates go up, lenders can choose to invest elsewhere for pretty much no risk – namely, U.S. government bonds.

And it’s not just in Silicon Valley. It’s happening across the board: Florida, New York, Texas… everywhere.

The upshot is, there is trouble brewing. And it has been brewing for a while. But the real estate cycle takes a while to turn.

So that doesn’t mean we’ll see the fallout from it this year. But if history is anything to go by, with the rate spread this low, you should expect it to play out within the next two years.

You can almost… almost… take that to the bank.

More Markets

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Today’s biggest losing ETFs…

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  • SPDR Kensho Clean Power ETF (CNRG) -1.9%

  • Invesco S&P MidCap Quality ETF (XMHQ) -1.9%

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  • Pacer US Small Cap Cash Cows 100 ETF (CALF) -1.8%



Kris Sayce
Editor, The Daily Cut