In October 1956, the people of Hungary revolted against a puppet government Soviet Russia had installed in Budapest. A small student demonstration escalated quickly into a broad and passionate uprising. Within two weeks, the Soviets had invaded Hungary with tank divisions, conducted targeted air strikes and shelled the city with heavy artillery bombardments. Such was the dramatic backdrop for a famous Olympic grudge match 60 years ago this week.
Training at altitude above Budapest, the Hungarian water polo team reluctantly viewed the siege of devastation the Russians laid upon Budapest. Traveling to Australia for the Olympic games, the Hungarians treated every match as a means not only to defend the gold medals they earned in Helsinki four years prior, but to salvage pride for their countrymen as well.
Hungary and the Soviet Union fatefully met in the semi-finals. The Hungarians, many feeling they could never return home, were eager to take their fight to the pool. A violent match ensued. In the final minutes of the fixture, the Russian Valentin Prokopov punched Hungarian Ervin Zádor above his eye, producing not only a large gash in Zádor's brow, but also an immense stream of dark blood that seeped into the pool. Prokopov's blow is now viewed in a more figurative light as Hungary roundly defeated their aggressors 4-0 and went on to win gold once more. The victory would prove only symbolic, however, in the greater struggle against the Soviet Union, as the mighty Russians swiftly crushed the Hungarian uprising and suppressed all public discussion of the revolt in the three decades that followed.
Water polo is similar to many land sports, such as soccer, hockey and lacrosse; the offense must intricately pass the ball to teammates in order to open the defense's positions, creating a clear shot on goal. In water polo, however, another battle is being waged beneath the water's surface as the opposing players fiercely push, pull and shove their way to dominance.
We believe the volatility across investment markets is being driven not by economic performance underneath the surface but by expectations of future performance. As we have stated for many years, property fundamental performance will ultimately dictate the value of commercial real estate assets. Beneath more topical discussions, we investigate data in search for historical precedent and relativity.
While the yield on the 10-year UST has risen 52 basis points since election day, in truth it has merely supercharged a trend that began on long prior. Since July 11th, the yield has risen 102 basis points in 108 trading sessions. This “shock and awe” campaign has heightened borrowing costs alongside heart rates across the investing community. But the below graph provides some historical perspective and a vision into periods where the yield has traded above 2.23 percent. Why this particular threshold? Because it is the average yield available to bond holders since early 2011 and also since the “Taper Tantrum” of 2013. In this light, the current yield of 2.4 percent, while higher than year-to-date observations, is not representative of a statistically-significant anomaly, but a resumption of normal business in the post-GFC era.
As the gray shading in the graph and as the rates table at the bottom of this note each suggest, the current range of borrowing costs is relatively in-line with a long-term averages in the current cycle and almost identical to that experienced one year ago. Given the cautionary underwriting broadly exhibited by commercial real estate investors for some time now, I do not expect many investors to have modeled benchmark interest rates in the ultra-low range experienced year-to-date, providing a necessary cushion for those rates to rise before the industry responds in an over-reactionary fashion.
Given its very high correlation with the 10-year UST, it isn’t surprising that similar conclusions can be drawn against the 10-year SWAP. Again, we map the periods wherein the current yield reflects historical norms, but, in this case, the threshold is 2.28 percent, which once more happens to be the prevailing average since early 2011 and the “Taper Tantrum,” as well as the approximate yield offered one year ago.
However, given the SWAP is more commonly associated with higher leverage in the CMBS market, the spike in the benchmark has proven more cumbersome to investors utilizing this lender type. What CMBS borrowers can be thankful for is the reversal in SWAP spreads to USTs that began abruptly in the fall of 2015 and continues to provide an effective discount, currently in a very steady range of 15-18 basis points.
Providers of real estate capital, and therefore this desk, pay close attention to the corporate bond market. Not only oracles of investor sentiment relating to corporate profitability, it also serves as a proxy for mortgage credit spreads. In this light, it is important not only to view corporate bond yields but also to analyze the premium they afford fixed-income investors above the risk-free rate.
At the bottom of this post is a table of corporate bond yields based on various credit ratings and maturities. Immediately below, we provide a graph of 10-year corporate bond yields across the credit rating spectrum. It is clear the yields have risen alongside risk-free rates such as the 10-year UST. But has the rise been basis-point-for-basis-point?
Although corporate bond yields have risen, they have done so in a pattern that has maintained a steady spread range to the 10-year UST. Taking a blend of the 10-year A and the 10-year BBB provides an excellent proxy for commercial mortgage credit spreads, which have hovered at approximately 160 basis points since August, even after the election.
Essentially, borrowers can be thankful that corporate bond spreads have not widened to compound the impact of rising benchmark interest rates. Meanwhile, they can manage the term of their borrowing where appropriate to manage debt service obligations and levered return metrics.
Singling out the 10-year BBB corporate bond from the 10-year A, we find a preferred proxy for capitalization rates. Consider a 10-year lease to Whole Foods versus a 10-year bond Whole Foods has guaranteed to repay upon maturity. As the yield on the public bonds rises, a capitalization rate offered by the acquisition of the Whole Foods-leased real estate asset becomes less attractive on a relative basis. It is with this logic in mind, that we analyze the below graph wherein, as with mortgage credit spreads, BBB spreads have moved in a range approximating 190 basis points for several weeks in the wake of the election and still down considerably from the wider spreads experienced in late 2015 and early 2016.
Meanwhile, as a result of the significant rise in the yield on the 10-year UST, capitalization rate spreads to the risk-free rate have compressed by approximately 75 basis points since the end of the third quarter. Depending on the benchmark one uses as a base capitalization rate, current cap rate spreads are much closer to long-term averages, as the graph below suggests.
The JPMorgan model suggests yields could rise approximately 40 basis points further before pressuring implied cap rates on REITs. The NCREIF model suggests the gap to pressure to be slightly smaller at approximately 20 basis points. Lastly, the RCA model finds that a broader set of transactions including any value as low as $2.5 million would be subject to capitalization rate expansion should the 10-year UST rise further. This concept is supported by the notion assets acquired/held by REITs and NCREIF members are typically lowered levered than those transactions included in RCA’s analysis.
In summary, rising interest rates have captivated pundits and investor underwriting over the last 30 days. And while it is admirable to be cognizant of rising benchmarks, such a rise is not in itself necessitating an offset in property valuations. I will continue to focus acutely on property fundamental performance, the ultimate driver of value. Ad interim, I believe:
Sources: HFF Research, Bloomberg, United States Treasury, Real Capital Analytics, National Council of Real Estate Investment Fiduciaries, JPMorgan
Jimmy Hinton serves as Managing Director of HFF, responsible for the firm’s national research efforts. Mr. Hinton works with the executive management team to assist in investor relations and to inform both HFF staff and firm clients with in-depth analysis of economic, property and capital market trends. He is also responsible for providing extensive market reports, client presentations and deal-specific analysis for debt placement and investment sales assignments. Mr. Hinton’s responsibilities include substantial interaction with pension funds, life insurance companies, regional and CMBS lenders, REITs, foreign investors and private equity funds.
During his tenure at HFF, Mr. Hinton has supported the execution of more than 150 commercial real estate transactions totaling more than $4.5 billion in 20 states. Mr. Hinton has experience in fixed- and adjustable-rate debt, mezzanine debt, construction loans and joint venture executions on behalf of clients engaged in the acquisition, development and recapitalization of property types including multi-housing, industrial, office, retail, medical office and storage properties.