Interest rates are the most important factor in asset valuation in my view. Assets such as stocks or real estate are very sensitive to interest rates. The basic premise is that the higher interest rates are, the lower the valuation needs to be on a stock or a piece of commercial real estate. The earnings yield or free cash flow yield on a stock, or the cap rate on a commercial real estate property must be higher than the yield on a 10 or 30 year U.S. government bond in most cases to be considered as an investment. The yield on the government bond is often referred to as the risk free rate. The difference between the earnings yield on a stock and the government bond yield is known as the “equity risk premium.” Other assets such as real estate should have a healthy premium over the risk free rate as well, adjusted for the risk of the investment. Higher risk should equal a higher spread, and thus higher reward if successful. Most people intuitively have some understanding of this concept. I thought I would provide a few examples to highlight the correlation.
Let’s say you are considering purchasing a stock that earns $1 per share and currently trades for $20 per share. That would equal an earnings yield of 5%. Should you buy it? A lot depends on the stability of earnings and the growth rate of earnings, but the first thing someone should do is compare that to the 30 year U.S. Treasury yield. Let’s say the investor wants a 2.5% equity risk premium over the bond yield, which is close to what the S&P 500 has averaged historically. If the treasury is yielding 2.5%, than you would likely purchase the stock. What would happen if the treasury yielded 4.5% instead? The investor would either have to accept a .5% equity risk premium at the current price, or wait for the stock to fall to a price that would give it a 2.5% premium. In this case that would be 7%. That means instead of a P/E of 20, or earnings yield of 5%, the stock would need to have a P/E of 14.3 to get the 7% earnings yield (1/14.3). That would mean the price would need to drop 28.5% to $14.30 per share. How about if the 30 year bond yielded 7.5%? In that case to keep the spread at 2.5% the stock price would need to fall 50% to $10 per share! This is the reason many people keep such a close eye on interest rates.
A more simplified example would be if someone were able to get a guaranteed 15% return with no risk, what return would they need to make on other assets to justify giving up the 15% return? The answer is quite a lot. It would depend on the investor, but most people and most certainly almost all retirees would be quite satisfied with doing nothing and receiving a 15% return. That could even make sense for a young investor as 15% annual returns grow money quickly.
Here is a more complicated example pertaining to commercial real estate. The main factors interest rates will influence with commercial real estate are the current cap rate, and the rate of interest paid on a commercial loan. They also affect mortgage rates and also home prices, but in this example we will focus on a commercial property.
Let’s say an investor finds an apartment building with $100,000 of net operating income (NOI) selling for $1,000,000, giving it a cap rate of 10%. This is where it gets interesting. With a low interest rate on a 20-year commercial loan of 5.5%, this is a strong deal! The investor would be looking at yearly debt service of ~$68,000 assuming a $200,000 or 20% down payment. That would give the investor a cash on cash return of 16% ($32,000/$200,000) starting in year one. Assuming the interest rate could be fixed for a long time, preferably ten years or more, the investor should be overjoyed at this kind of return.
Alternatively, let’s say times have changed and interest rates are much higher. The property is still selling for $1,000,000. Instead of getting a loan with a 5.5% interest rate, commercial loans have 13% as the going interest rate. Instead of making $32,000 per year in cash flow, the investor is now losing $15,000 per year due to the yearly debt service jumping to $115,000 due to the higher interest rate! What was once a great deal is now likely to be a poor investment even though the price was the same.
That was just a simplified example, in the real world if interest rates rose that much, the price of the property would have gone down as well. No one would be able to finance the property at the current price and interest rate, so the price would have to fall to reflect that. Also, a 10% cap rate would be unattractive if long-term government bonds were yielding a similar amount. Much like the example with earnings yields and stocks, cap rates will also be compared to the risk free rate. Most likely, a premium that is much higher than the risk free rate would be required by investors in real estate as well. For example, if that same building were for sale and the risk free rate was 10% and investors required a 4% premium on top of that for the risk and hassle of owning real estate, the building would need to be purchased at a price of ~$715,000. ($100,000/.14) That would be a 28.5% drop in price. Alternatively, if the risk free rate was 3% which is close to what it is today, and investors demanded the same 4% premium, the building would sell for around ~$1,430,000, or 43% above the original price. Nothing has changed about the property, just the rate of return required by investors due to the change in interest rates.
I hope these simplified examples have shown what interest rates do to asset values. In the real world it is a little more complicated as other factors come into play as well. This was just meant as a simple guide of what interest rates can do to asset valuation. When investing, always compare the current yield to the yield you could get risk free. A lot of financial bubbles would not have happened had this been commonly practiced. Just be smart and always demand a healthy premium in any investment over the risk free rate and results should be satisfactory.