Ah, the venerable battle of investments, a financial version of the chicken and the egg loop. On one side, we have real estate—the timeless darling of investors seeking a tangible asset. On the opposite side of the ring stands bonds, offering fixed returns and often seen as a safe refuge during times of economic upheaval. While each has its own merits and demerits, the tussle between bond yields and real estate cap rates has long fascinated investors and analysts alike. Today, however, the balance seems to have tilted in favour of bonds, and it’s worth taking a look at why.
The 2023 bond market, particularly in the U.S., is abuzz with higher yields. The 10-year Treasury bond yields have hit 16-year highs, and the Federal Reserve seems keen on raising rates, although at a gentler pace compared to 2022. This signals the end of a prolonged era of low interest rates that began following the 2008 Financial Crisis.
As the returns on bonds go up, they become more attractive compared to real estate investments. To put it bluntly, the real estate market is experiencing a bit of a buyer’s drought. The cap rates, which are essentially the rate of return on a real estate investment, are now lagging behind bond yields for the first time since 2008. According to Reventure Consulting, the 10-year note yield has surpassed the median cap rate, making bonds more appealing from a returns perspective.
This shift in allure isn’t just a theoretical one; the market has reacted, and how. Investor purchases in real estate have plummeted by a staggering 45% this year in the US. The prospects don’t look too bright for the real estate market either. Mortgage rates, which have already tripled over the past two years, are projected to hover between 9% and 10% by early 2024. Meanwhile, in Australia, an 11% drop in national house prices is anticipated by the end of 2023.
This waning enthusiasm for real estate isn’t a first. Similar patterns were observed in the early 1980s and 2000s when bond yields surged. The dynamic interplay between the bond and real estate markets isn’t a new phenomenon; it’s a cyclical pattern influenced by broader economic trends and central bank policies.
Rising bond yields are prompting a reassessment among investors. The rational course of action appears to be reallocating capital from real estate to bonds, aiming for a more stable return. As mortgage rates climb, the barrier to entry for real estate investments is also becoming formidable, likely steering even more capital towards bonds.
Yet, even as the pendulum swings away from real estate, it’s worth noting that the median sales price of homes continues to rise. Paradoxical? Perhaps. But it also speaks to the issue of affordability, which has become so pronounced that not even investors find buying a viable option.
So, where does that leave us? In a rather curious position. The upshot of all this is that the rising bond yields and mortgage rates are reshaping investor behaviour in a manner unlike the last decade. What was once considered a slam dunk—pouring money into real estate—is now a question of financial calculus.
It’s a tug-of-war, and for now, bonds are pulling stronger. But as any seasoned investor will tell you, markets are fickle, and tides can turn quickly. The only certainty is change, and for those nimble enough to adapt, opportunities are always around the corner.
