From Jason Payne, Market News Analyst …
I’ve got more good news for you today, Moguls.
(Here’s hoping you enjoy reading this week’s Market News Update as much as I have enjoyed doing the underlying research!)
But first, here’s a quick recap of “the big picture”, to refresh your memory…
As mentioned at the end of last week’s encouraging report, we here at Real Estate Mogul look forward to watching numerous property types reestablish themselves as premier vehicles for reliably high-yielding investment returns during the next few years.
Specifically, we expect the real estate industry to generate higher investment yields than most (if not all) other major asset classes, including corporate equities and investment grade corporate bonds, as well as “risk-free” government securities.
And although there will surely be a few unpredictable bumps in the road, we expect real estate’s relative outperformance to continue gaining momentum as our industry continues to regain its basic fundamental health, and as the broader U.S. economy is gradually weaned off its current diet of economic stimulus policies.
These rosy expectations are not the result of “wishful thinking” on my part, nor do they reflect any self-serving propaganda from Real Estate Mogul’s editorial board.
(As an independent analyst, I don’t submit my reports to anybody for pre-approval...
...not even to the gentlemen who sign my paychecks.)
Instead, my optimism on behalf of all real estate investors is derived from three primary sources:
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Professional Experience. In my former career as a Wall Street research analyst, I accrued more than six years of professional experience in an award-winning investment research department – with a specialized focus on real estate investments.
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Proprietary Analytical Tools. As I continue to find my footing in this new role with Mogul, I am thoroughly enjoying an ever-growing arsenal of proprietary analytical tools – which are helpful for exploring numerous fundamental investing metrics, both inside and outside of the real estate industry.
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Supporting Data. Recent market data supports all the expectations described above.
And as long as we’re on the subject of market data, let me tell you about the latest developments related to last week’s encouraging analysis of investment yields for residential property investors…
Resilient Residential Property Yields Buck the Downward Trend
During the last few days, Zillow released its latest price- and rent-related data for the month of October 2013, which supplied us with the latest raw materials for Mogul’s proprietary calculation of net yields for U.S. residential real estate.
As illustrated in the chart below, the average net yield for residential rents held steady at 4.6% last month, despite modest declines for each other major asset class.
Here, take a look for yourself:
Sources: Zillow, U.S. Federal Reserve, Robert J. Shiller & REIology Research
But that’s not all, folks. Even better than the resilience of residential housing yields is the impressive “spread” that is returning to the realm of mortgage arbitrage!
–crickets chirping–
That’s right… The spread for mortgage arbitrage… It’s getting bigger!
–more crickets chirping–
Okay, I get it. Some of you don’t lie awake at night, dreaming of ways to make easy money with mortgage arbitrage – and that’s okay, I guess.
But perhaps this is only because you’ve never been taught how simple it can be to turn a profit with mortgage arbitrage, and how important this concept is for real estate investors. (In my opinion, it ranks right up there with net yield.)
So allow me to explain…
Mortgage Arbitrage 101
As thoroughly explained in last week’s introduction to net yield analysis, there’s no denying the fact that net yield is a vital calculation for real estate investors of all stripes.
This important metric not only allows investors to compare the profitability of different investment opportunities within the real estate industry, it also facilitates their comparison with many other investment opportunities from entirely separate asset classes.
But there is a major limitation to this sort of yield analysis, even when the analysis is sophisticated enough to replace real estate assets’ gross rental income with a thorough calculation of net rental income (as ours does).
And this limitation can be summarized with two words: mortgages and interest.
Mortgages represent a huge variable in most investors’ real estate pursuits, because most investors are either unwilling or unable to pay cash for all their properties. In addition to requiring a significant down payment, mortgages also require a regular schedule of sizeable interest payments…
…which cannot be reasonably incorporated into macroeconomic net yield calculations (such as ours).
And that is why many savvy real estate investors try to keep one eye on the market’s prevailing mortgage rates, while still paying close attention to investment yields. If they wait patiently for the right timing, these investors can capitalize on the “spread” that exists between the two metrics.
Sometimes mortgage rates are so high that a cash-strapped investor must choose to bypass even the juiciest real estate yields, because he simply cannot afford to make those pesky interest payments each month.
For example, if a cash-strapped investor would be forced to pay 6.0% interest on his mortgage while only earning a 4.0% yield from the underlying property, then he would probably reject that deal faster than your Uncle Bob rejects telemarketers at dinnertime.
But if mortgage rates drop significantly below the expected yield on real estate investments, then a whole new world of possibilities begins to emerge.
On those tantalizing occasions, even the investors who are loaded with cash may be wise to consider mortgage financing for their property purchases.
You see, when mortgage rates drop below property yields, the supply of new income (from a new property’s net rents) would be greater than the bank's demand for new expenses (in the form of new mortgage payments), and savvy investors can profit handsomely from this disparity.
It’s called “mortgage arbitrage”.
And it could be a viable option for your own portfolio during the next few months.
Which brings me back to this week’s latest supply of encouraging market data…
Is Santa Bringing a Special Gift for Mortgage Arbitrageurs?
According to recent data from the St. Louis Federal Reserve, the average interest rate for benchmark 30-year fixed-rate mortgages has declined approximately 40 basis points during recent months, from a peak of 4.5% at the end of August to only 4.1% at the end of October.
As discussed in this recent lesson, mortgage rates recently spiked to two-year highs during the final weeks of summer, driven by fears that the U.S. Federal Reserve would soon begin tapering its latest round of “easy money” economic stimulus policies.
But as discussed in this other lesson, mortgage rates have recently begun to decline once again, as investors grow increasingly confident the Fed will delay and/or modify its tapering initiatives.
And since the resilient yield for U.S. residential real estate was able to hold steady at 4.6% last month, the “spread” between investment yields and mortgage rates has now increased to approximately 50 basis points (4.6% average yield minus 4.1% average mortgage rate = 50 basis points).
Sources: Zillow, U.S. Federal Reserve & REIology Research
As illustrated in the chart above, mortgage rates were significantly higher than real estate investment yields during late 2010 and early 2011, when the Fed was still in the early stages of its current five-year (and counting) “easy money” free-for-all.
But as Bernanke & Co.’s second and third rounds of quantitative easing began to gain traction, mortgage rates began to fall back down to generational lows, even dipping to 3.3% in November 2012.
Simultaneously, the nascent recovery in U.S. housing market fundamentals allowed residential real estate yields to reach 4.9% last November, representing an enticing spread of 160 basis points for any investors who were able to strike while the iron was hot.
Of course, as encouraging as the current trend may be, today’s spread of 50 basis points is still a far cry from last November’s mortgage arbitrage bonanza. But with the wind at their backs and at least a few more months of government-sponsored stimulus on tap, real estate investors may soon be able to enjoy another round of lucrative “spread surfing”.
So keep your eyes peeled, gang. These are still interesting times for our industry!
Jason Payne’s next Market News Update is scheduled for Wednesday, Dec. 4th.