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Zero To Five
The Risk-Free Rate
In Part One we discussed the 40-year decline of long-term interest rates.
In Part Two, I explained how long rates impact the multiples used to value assets.
Combing those two pieces, asset values are driven upwards by…
Driving Increased Multiples
In an environment of high multiples, every source of cash flow becomes more valuable.
When high multiples are combined with ultra-low rates on debt, we can see asset prices rapidly inflate due to:
Multiples inflating of values
Greatly increased ability to pay
2022 saw a “melt up” in many markets.
Yield On Cash
In addition, short-term rates impact investors.
When I started my working life (London 1990) my “portfolio” consisted of a savings account at Barclays Bank. It paid me a modest amount of interest (high single figures) and I topped it up monthly. It was a simple system that let me focus on my most valuable asset (an applied education in finance, investing and money).
Over the last ten years, we’ve raised a generation who didn’t get the experience of earning safe, but boring, interest.1
Today, through a money market fund, we can receive a 5% return on cash for doing “nothing.”
If this shift in short-term rates persists then it will change how assets are valued, relative to each other.
Here is a calculation I recommend you do with your family balance sheet. Start by making a list of the low-, non- and negative-yielding assets.
Low- and negative-yielding real estate
Net Realizable value in recreational assets
Capital tied up in non-yielding alternatives (gold, commodities, crypto)
Lump all those assets together.
Get a total figure.
Add up the annual cost of ownership.
Consider the annual commitment in time & emotion.
Multiply the total by 5% to see forgone income.
The longer an attractive risk-free rate endures, the more people will make the above calculation. Some of these people will…
Liquidate some, or all, of the assets.
Invest the capital in a money market fund (VMFXX).
Collect 5% per annum, current yield.
Maintain freedom of allocation with time, capital and emotion.
Like falling multiples, increasing risk-free rates provides a headwind for future appreciation.
Residential & Low Yield Real Estate
This calculation works more broadly than with speculative and depreciating assets.
When I do an implied yield calculation on where we live, I discover the yield is 2%.2
Every new buyer is paying a hefty premium in the current market.
In our neighborhood, the “cost to rent” is less than half the “cost to own.”
Gaps this big tend to close over time.
One way they close is increased supply. Interestingly, supply is constrained because many owners don’t want to give up their ultra-low mortgage rate.
But not everyone…
My neighbor just put his house on the market.
Two have left the nest, the other leaving in a year
Sitting in a big house, great part of town
His family can take money off the table, live debt free and earn a decent return on freed up capital.
All over the US, marginal buyers and sellers will be doing this calculation.
The math scales up and down the value chain.
It’s another source of headwind for capital appreciation.
Vacation Real Estate
The vacation markets the buyer’s calculation is different. Here’s where the risk-free rate can have a big impact.
In other markets I follow:
$1-2 million entry cost
$25,000-50,000 carrying cost
Low-utilization by the owner (25 nights a year)
When the market is appreciating (due to a 40-year decline in long rates), it is easy to ignore the carrying cost, particularly when the yield on cash is ZERO.
Now that a 5% risk-free rate is available, the calculation might go like this…
Ownership is, effectively, costing $1,000 per night. (Carrying Cost divided by Annual Nights)
If capital is reallocated, instead of paying $1,000 a night, the investor could be earning the equivalent of $2,000 per night (5% times $1 million divided by 25 nights).
When money is “free” it’s easy to ignore the math. With 7% mortgage rates and 5% risk-free rates, money is not free.
Values have yet to reflect this shift in the price of money.
Owners: Pay attention to the net cash yield the property is generating and compare that to the net realizable value of the asset.
Put simply => net cash flow for the last 12 months divided by the Zillow Value (adjusted for capital gains tax and agents’ fees)
Buyers: Calculate the true cost of ownership (including opportunity cost of capital) on a per night basis.
You may have grown used to your hurdle rate being “zero.” It’s not zero any more and there are headwinds you might not have faced in your investing career.
Next time we will convert the above to “time”.
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Yield calculated as market rent less insurance/taxes divided by Zillow value. True yield will be lower due to impact of depreciation and taxes.