By: Tom Noble, COO & SVP, Archway Capital
Inflation and the federal reserve’s subsequent monetary policy to reduce it towards the bank’s 2% target has had a chilling effect on real estate markets across asset classes and geographies but there are compelling merits to investing in short term, high yield real estate loans during times of rising interest rates.
The Fed’s strategy which has included raising the federal fund’s rate to between 5.25% and 5.50% as well as shrinking the amount of bonds held on its balance sheet has led to the US bond market having its worst year performance in its history when it lost over 13% in 2022 as measured by the US Agg Bond Index. Investing in short term high coupon loans collateralized by real estate can insulate an investor from the negative effects of rising interest rates in three ways:
Short Duration Portfolios Can Be Reinvested At Higher Yields More Quickly
Investors with dry powder can take advantage of the opportunity afforded by rising rates to invest in new loans at higher yields. A portfolio of short-term loans will payoff turnover at a greater rate than a portfolio of long-term loans which increases the amount of fresh cash available to deploy into higher yielding loans and drive higher returns.
Higher Starting Yields Can Make High Yield Loans Relatively More Attractive
High coupon investments retain more of their value in a rising rate environment relative to low coupon investments because high coupon investments retain a higher portion of their yield advantage or spread over less risky treasury bonds. For example, contemplate two loans where one is yielding 4% and a second loan is yielding 5% in a world where treasury yields go from 2% to 3%. The first loan has lost half of its spread while the second has only lost a third.
Quality Collateral Can Protect Principal During Times of Economic Slowdown
The federal reserve is raising rates to slow down the economy and bring inflation down to its 2% target. A second order effect of this monetary policy can be an increase in corporate bankruptcies, loan defaults and general stress in the economy. Relative to unsecured loans, portfolios of loans secured by real property assets can be better positioned to absorb delinquencies and a slowdown in the broader economy due to the downside protection conferred by the collateral base.
In conclusion, rising interest rates can have substantial negative effects on the values of a wide variety of investment portfolios and asset classes as investors demand higher compensation for bearing risk as the yields on risk free bonds increase. Investments in short term, high yield real estate loans have characteristics that can be favorable in inflationary, rising rate environments and can provide an important piece of a diversified portfolio.
