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Monday, April 4, 2011

What's the Downside?

By Earl Webb (Chicago)

Even in the current market, where cap rates have contracted on most asset types over the past 18 months, real estate is considered a higher-yielding asset than monetary assets like stocks and bonds, and a prudent use for excess investor cash. As such, we continue to see investor interest rise across all asset types and classes, although the rise in value is beginning to slow its trajectory a bit.

 Given that short-term monetary investment yields are still extremely low, what could be causing this slowdown in value accretion? Could the slowdown be caused by notable investor withdrawals from the market? Not likely, since many investors still have (collectively) billions of uninvested real estate dollars. Could it be that supply of product is rapidly increasing? Again, not likely, as supply has certainly increased but not near to the degree of equalizing investor demand. Could it be something that nobody really wants to talk about? Absolutely.

 The elephant in the real estate transaction room is a potential increase in interest rates, which is beginning to look more likely as 2011 progresses. Austerity plans in local and national government are having difficulty gaining traction, and existing bond investors are beginning to worry about possible inflation. Guess what? In the investment markets, perception rapidly becomes reality and if this condition persists (and the Fed continues to send mixed inflation and policy signals), then we could see a ramp up in funding costs later this year. My guess is that a 200 basis point rise in funding rates would cause a rapid ripple effect of corporate slowdown, financial institution capital withdrawal, rising mortgage costs and possible loan defaults, and rising cap rate expectations.

 Here's hoping that policymakers move the austerity balls forward carefully, but steadily, in order to keep inflation down and the markets on a steady recovery path.

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