How Rates are Burning Real Estate Investors

Welcome to Capital Call! The OneFund newsletter.

We’re doing something a little different with this edition and discussing… real estate!

I’ll be the first to admit I am no expert when it comes to real estate. At OneFund, we focus exclusively on private equity, but many of our clients often invest in real estate outside our platform. Recently, I’ve repeatedly been seeing an issue impacting those clients. Let’s talk about it.

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Rates are going up, values are flat (or even going down)

When I talk to some of our clients about their real estate investments, they often talk about the exuberance that everyone felt in 2020. Rates were low and prices for commercial real estate were cheap. Who wouldn’t want to buy in this environment?

In the pandemic, commercial real estate was selling at a discount to prices it had been selling at the year before. Additionally, rates were at all-time lows, approaching 3 or even 2 percent.

It was the perfect time to buy, right?

Well, one thing you may have also noticed about the above chart isn’t just the dip in values in 2020, but the dip in values happening now. According to the Fed, commercial real estate prices overall are down about -7.5% verse this time last year. The data below from Green Street shows how that has played out across commercial real estate sectors.

But the story of woe doesn’t end there… not only are property values down but so are cash flows from these supposedly “income-earning assets”. Interest rates have climbed from the ~3% of 4 years ago and are approaching 7% or even 8%.

Unfortunately, a lot of loans are taken out on adjustable rates and when rates go from 3% to 7.5%… well, you can do the math on what that does to debt servicing. Not to mention the potential impact to property operating expenses.

So what do I take away from this?

First, whenever someone pitches something as a hot way to grow capital, take on less risk, and generate cash flow, look at it twice. Real estate is often touted as a way to generate cash and returns with a stable asset, your new property, securing the whole investment. Well, when the value of that asset is sinking and your costs are rising, it can be an anchor instead of a buoy. Remind anyone of 2007?

Second, most people overestimate how much diversity real estate adds to their portfolio. Of Americans who own a home, that home typically constitutes about 45% of their net worth. Granted, there is a difference between residential and commercial real estate, but still, Americans often find themselves already extremely concentrated in real estate.

Thank you for reading.

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