The bond markets are panicking about President-elect Trump’s proposed inflationary policies. Bonds have lost over $1 trillion in value, globally, since the election. Ten-year Treasury rates rose by 27 basis points over the two days after the election, their biggest jump since October of 2011. Popular thinking is that higher rates are bad for real estate, as evidenced by the 4.2% drop in REIT stocks in the two days following the election.
If Trump has his way with tax cuts, infrastructure spending, the border wall policies, and immigration policies that would reduce the supply of low cost labor, there is no doubt that inflation and higher interest rates would follow (see our previous story in Barrons: If You Build it They Won't Come - Five Ways that Trump's Wall would affect Real Estate). Some of these policies could hurt real estate in ways unrelated to inflation, by restricting capital flows to the US and dampening population growth. The immediate impact of higher interest rates would likely be negative for REITs and for real estate values, because higher cost debt reduces equity returns. Over the longer term, however, large deficits stimulate the economy, and inflation increases the value of hard assets.
The conventional thinking goes like this: real estate values are based on cap rates (property net income/ property value). When interest rates go up, cap rates have to increase to keep real estate competitive with fixed income products, and this drives values down. This analysis misses real estate’s essential role as an inflation hedge. Inflation drives up rents, which increases property values. In an inflationary environment, investors derive most of their return on real estate from appreciation, not from cash flow. As a result, cap rates go up far less than interest rates do. Real estate investors do demand higher returns, but they expect to get much more appreciation in value.
Back in the late 1970’s and early 80’s, cap rates were up to 600 bp lower than 10 year Treasury rates. During the real estate recession of the early 1990’s the trend reversed itself. Interest rates fell due to the weak economy, and cap rates rose, due to the low expectations for growth in real estate values. This happened again in 2008, when cap rates increased while interest rates fell.
Historically, real estate values have increased when interest rates are rising. Another way to put this is that real estate is negatively correlated to bond values. Between 1978 and 2014, real estate had a -0.27 correlation with investment grade bonds, according to a Pension Real Estate Association (PREA) study. In other words real estate values tend to increase when bond prices decrease (bond prices go down when interest rates go up).
So what does all of this mean for real estate values in the Trump era? If we are truly heading for a period of inflationary deficit spending, direct property investments should provide a good inflation hedge over the term of Trump’s presidency. This is particularly true for hotels and apartments, which have short leases. On the other hand, office buildings and industrial properties that are locked in to long term leases will take longer to adjust.
We may also see a divergence between REIT stocks and direct real estate values. This has certainly been true of REIT prices since the election. Unlike real estate funds and direct real estate, REITs are subject to stock market volatility and the whims of short term capital flows.
They could continue to take a beating due to the popular perception that they behave like bonds.
Of course, inflationary expectations are only one factor. Trade policy and immigration policy will also have a major impact on capital flows and the overall demand for space. The jury is still out on the combined effect of these factors. Just don’t blame whatever happens on inflation.