Over the course of June and July, Britain roiled international markets by voting to leave the European Union, Italy’s struggling banks pushed the Eurozone closer to a new crisis and the U.S. Federal Reserve voiced fears that global economic growth is on unstable footing. And yet the reaction to all of this by many in New York’s real estate industry was relief.
Eight years after one of the worst financial crises in history, we have become stuck in a perverse dynamic where bad news for the world economy is often good news for the city’s property market. A lot of that has to do with the outsized impact of bond markets on real estate.
As a rule of thumb, economic uncertainty causes bond yields to drop (with a few exceptions). And lower bond yields are often great news for property investors, especially in the Big Apple, because they make real estate look more attractive and push down the cost of financing.
In the years following the 2008 financial crisis, central banks in the U.S. and abroad pumped trillions of dollars into bond markets in an attempt to encourage investment and stimulate economic expansion. The influx of cash artificially inflated both government and private sector bond prices, which in turn lowered their yield.
Following the Brexit vote on June 23, the Federal Reserve signaled a reluctance to allow interest rates to rise again, citing threats to the country’s economic recovery. The yield on 10-year U.S. Treasury bonds fell to an all-time low of 1.367 percent on July 5 before recovering slightly.
These low rates trickle down to New York’s real estate market in various ways.
“The most direct mechanism is probably through the cap rate,” said Savills Studley’s chief economist, Heidi Learner, referring to a property’s annual income divided by its purchase price. “We have seen a secular decline in cap rates that has tended to coincide with the decline in Treasury yields,” she added.
How it works
Cap rates fall when property sales prices grow at a faster pace than annual rental income, which is why economists generally view declining cap rates as an indicator of a rising market.
And while cap rates are a crucial metric that commercial real estate investors use to price assets, what matters most is the spread between the cap rate and benchmark bonds, most notably the 10-year Treasury.
For example, a 5 percent cap rate on a Midtown office building is a decent return if the virtually risk-free Treasury yields 1.5 percent. But few investors would take a 5 percent return on an office building if they could get 6 percent on a government bond, which is why cap rates in the medium run tend to move in tandem with Treasury yields.
Broadly speaking, that is what has happened over the past eight years in New York commercial real estate. As Treasury yields remained subdued, Manhattan’s average office cap rates fell to a low of 4.4 percent at the end of 2015, according to the research firm Real Capital Analytics.
In New York’s residential market, the spread between real estate and Treasury bond returns is less important, Engel & Völkers’ New York CEO Stuart Siegel told The Real Deal. That’s because many apartment buyers aren’t just looking for an income-producing investment; many are looking for a full-time residence or a pied-à-terre.
Here, bond markets play a bigger role through their impact on exchange rates, according to industry players. When bond yields are high in the U.S. but low abroad, that tends to attract foreign money to the states and puts upward pressure on the U.S. dollar, which in turn affects how foreigners invest in American real estate.
If foreigners believe that the dollar will rise in coming years, they may be more inclined to invest in Manhattan real estate to benefit from that appreciation, and vice versa, sources said.
“The world map has been essentially redrawn in the last couple of weeks,” Robert Dankner, president of brokerage Prime Manhattan Residential said, adding that London is now more or less “off the table” for investors amid uncertainty over its political and economic future.
Bond markets also impact the real estate industry through the cost of debt. In the States, 10-year Treasury yields are used as guideline rates for virtually all fixed-income assets, including residential and commercial mortgages.
If Treasury yields fall, mortgage interest rates tend to follow suit, said Jacob Kirkegaard, an economist at the Peterson Institute for International Economics. “Generally, the correlation is fairly straightforward and fairly quick,” he noted.
Of course cap rates, exchange rates and mortgage rates often fluctuate for reasons unrelated to bond markets. But other things being equal, high bond prices and low yields mean profits for New York’s real estate industry.
Where it gets tricky
Yet what if the global bond markets send mixed signals?
In late 2015 and early 2016, fears over a weakening Chinese economy and lackluster earnings from U.S. companies sent global markets into a tailspin. Seeking safety, investors flocked to U.S. Treasury bonds, sending the 10-year yield down from 2.34 percent in early November to 1.57 percent by February 11. With a bit of a time lag, mortgage rates soon followed suit: The Mortgage Bankers Association’s 30-year fixed rate fell from 4.2 percent on January 6 to 3.83 percent by March 2.
But there was a flip side. As investors flocked to the safety of government bonds, they ditched fixed-income assets deemed riskier and more vulnerable to an economic downturn. That included commercial mortgage-backed securities.
Spreads between CMBS and Treasury yields rose dramatically and CMBS issuance plummeted earlier in the year. That caused a momentary panic in New York’s commercial real estate market, which relies on securitized lending to keep many of its deals flowing.
As the cost of CMBS debt rose and cap rates continued to stay low, commercial real estate investors’ profit margins were squeezed, said Jim Costello, senior vice president at RCA.
In other words, New York’s real estate industry got caught in a tug-of -war between two competing bond market forces: the boost from low Treasury yields and the drag from the volatile CMBS market.
In contrast, the recent market hiccup following the Brexit referendum has had a less ambiguous impact. Treasury yields are down, but so are CMBS yields. Costello argued that U.S. investors are simply less anxious today than they were in early 2016 and less bearish on mortgage-backed securities in the wake of the Brexit vote.
After all, he pointed out, a mere 3 percent of U.S. exports go to the United Kingdom, meaning Brexit will have a minimal direct impact on the U.S. economy and, by extension, its commercial property market.
“Earlier in the year, there was uncertainty about [American] corporations and uncertainty in the [U.S.] economy,” he said. “That’s different now. Brexit is not as bad a situation for the U.S. as people initially feared.”