I received a comment from my good friend Jim Copley on my recent post about sizzling property markets. Jim is the CEO of the CROM Corporation, the nations’s leading maker of highly-engineered municipal water storage systems. Jim is the kind of manager I would be proud to go to war with. (If you are in need of a 2 million gallon water tank please let me know.) I am proud that Rutledge Capital has an investment in Jim’s company. Here is my response.
The abrupt drop in interest rates over last couple years has led to the complete re-pricing of residential and commercial real estate, as owners re-financed mortgages at the lower rates.
Essentially, we have re-capitalized the future stream of rental value embodied in the current housing stock at lower interest rates. The securitization of the US mortgage market allowed this to happen.
This leads to two sorts of problems. Some people look at the rising prices of the past year and think they will rise forever. They are the buyers lining up to draw straws for new developments today. We have seen this movie before in 1990. If you have been infected with this disease, best thing is to lie down until it goes away.
Recent price increases reflect lower interest rates, not rising future rent values (not higher future income streams), so are one-time events. In fact, the most recent report on existing home prices from the National Association of Realtors shows that prices peaked last June and have fallen since then. It is important not to get swept up in the excitement today.
The second thing I hear is talk about a real estate bubble. I don’t find that worry credible because I believe interest rates will not rise much from current levels. Interest rates are ultimately determined by inflation, which I believe will remain in the 1-3% zone for a long time, both for domestic reasons (Fed, productivity growth) and global reasons (professional service price arbitrage with the countries in Asia that have fiber-optic connections with the US.) Cash returns on commercial real estate, although much lower than 2 years ago, are still somewhat attractive relative to bond yields. And both the economy and employment are rising, which will keep cash flow growing.