A primary axiom in real estate investing is that sellers think their property is worth more than a buyer does, and buyers think a property is worth less than the price the seller is asking. Some people might call that greed, some would call it human nature. But something else is occurring in the marketplace today other than the laws of human nature and traditional supply and demand that is causing the bid/ask gap to widen.
Real Capital Analytics notes that over the first two months of 2018 transaction volume among all property asset classes (except for industrial) declined to the lowest level in the past five years. In fact, beginning in 2015, transaction volumes across all property types have been steadily declining year-over-year.’
We believe this downward trend in sales transaction volume will continue through 2018 and beyond as buyers anticipate rising interest rates while sellers – having become accustomed to steadily declining cap rates and rising real estate prices – refuse to sell for less than what they perceive the value of their property to be.
Rising interest rates are also affecting the bond market. Similar to the inverse relationship between commercial real estate cap rates and asset values, rising interest rates cause bond yields to rise and bond prices to decline. The difference between the two – at least in the short term – is that when businesses go to the bond market to issue debt they need the money sooner rather than later and are forced to pay the going rate in the bond market. Real estate owners oftentimes wait to sell until their loan becomes due (remember that many commercial real estate loans are for five years or less) before making the decision to refinance at a higher interest rate or sell into a declining market.
Do Cap Rates Always Decline?
For real estate investors who have been in the market less than 10 years, the answer to this is ‘yes’, because that’s all that they know. Back in 2008 when the Global Financial Crisis hit property values declined and cap rates began to rise, as one would expect. According to Real Capital Analytics and the Federal Reserve Bank of St. Louis, between 2008 and 2010 major market cap rates increased from about 6.00% to 6.75%, while non-major market cap rates rose from about 7.10% to 7.60%.
But then beginning in 2010, as quantitative easing money filtered through the market, cap rates in both major and secondary market began to decline year after year. Through the end of 2017 major market cap rates stand at around 5.25% while secondary market cap rates are about 6.60%. Those low cap rates explain why real estate prices have risen so much over the past few years, and why there is so much speculative development taking place in the market today.
In most real estate cycles, the primary increase in real estate prices isn’t attributed to exceptionally strong fundamentals or a low supply/high demand equation. Rather, due to cap rate compression and these historically low cap rates, which have been caused by the Federal Reserve’s and global central banks’ zero- and negative-interest rate policies. To readers of our quarterly newsletters and weekly blog posts, it’s no secret that easy money is going away and interest rates are beginning to rise.
As we pointed out in a March blog, The Housing Bubble’s Slow Leak, and in last quarter’s newsletter, financial markets are leading indicators of what is being forecast for the economy. It is only logical to conclude that a softer real estate market is ahead. This does not even take into consideration the vast amount of new construction in the pipeline that will come to market in 2018 and 2019 during a period of rising interest rates.
Will Foreign Investors Save The Day?
As we write this newsletter the US dollar is strengthening compared to all other currencies. Emerging markets whose global debt is priced in the US dollar are facing a liquidity squeeze. As their dollar reserves become depleted these countries are forced to compete with other countries to buy more dollars with their devalued home currency. The Euro, the Japanese Yen and foreign currencies in other major markets have also declined significantly vs. the US dollar over the past few months. But we believe this is an aberration rather than the beginning of a long-term strong dollar trend. Since February 2018 the US Dollar Index – which measures the strength of the US dollar compared to a basket of the U.S. trade partners’ currencies – has risen by about 6%. The rising Index has more to do with perceived risk created by geopolitical gamesmanship and the on-again-off-again trade wars and tariffs than with strong fundamentals of the US dollar. It is interesting to note that while China has agreed to buy more from the U.S. as a result of President Trump’s tariffs, the value of the Chinese Yuan has weakened from 6.273 per US dollar the beginning of February 2018 to 6.384 today.
A recent report by PricewaterhouseCoopers notes that investment capital from the Middle East has all but stopped coming into the U.S., while capital inflows from Asia have seen annual declines of 7% since 2015. Investment volume into the U.S. from both Singapore and Canada has increased significantly, but this has more to do with the weak price of oil over the past few years – a price that has begun to rise – and the current strength of the US dollar vs. the local currencies.
Oklahoma, Oil, Amazon, and TwinRock
Over the past 12 months the price of oil has risen significantly. In June 2017 WTI Crude was $42.74. Today the price is $72.51, an increase of about 70% in less than one year. The rising price of oil will likely weaken the strong US dollar and reduce the flow of investment capital into the U.S. But the rising price of oil most definitely helps our TwinRock properties in Oklahoma (and validated our timing to invest in Alberta, CA).
A recent article in the Wall Street Journal notes that rising crude-oil prices along with lower land leasing costs have boosted shale-drilling activity in other U.S. oil producing regions outside of the Texas Permian Basin. The Granite Wash basin in Oklahoma has seen the number of oil rigs more than quadruple since May 2016, while the rig count in Oklahoma’s Cana Woodford basin has nearly tripled over the same time period. The Cana Woodford basin is home to the Stack field, which is the third most active oil field in the entire United States. Oil and natural gas drilling activity is so strong that construction of another pipeline system has already begun and will become operational mid-2019. The 65-mile-long Cimarron Express Pipeline will have an initial capacity of 90,000 barrels per day and is designed to expand to 175,000 barrels per day.
While Amazon isn’t in the oil business – at least for the time being – the company’s expansion plans in Oklahoma City will also help our property investments there. According to The Oklahoman newspaper Amazon is in talks to construct a multistory fulfillment center warehouse near Will Rogers World Airport. The fulfillment center represents an investment of over $100 million and potentially more than 2,000 new jobs. This would be Amazon’s second investment in Oklahoma City. The company is currently constructing a $3 million, 300,000 square foot ‘Sortation Center’ that will be used to sort and organize packaged customer orders prior to delivery.
We look forward to sharing our thoughts again in our next quarterly report. In the meantime, should you have any questions, we look forward to hearing from you.
Very truly yours,
Chief Executive and Investment Officer