In the midst of a market disjunction

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Had breakfast with a really experienced broker this morning, a guy who I think of as kind of a mentor. He started in real estate in the early 1980s and has bought and sold an unbelievable number of properties in the Echo Park area since then.

I complained to him that the market feels pretty weird right now, with almost all sellers of apartment buildings asking for insane prices (GRMs of 13x, 14x and up – for more on this, see this post), given the change in interest rates over the past 1-2 months. (Note: The triplex I have on the market, 1142 N. Virgil, is priced appropriately for the interest rate environment, because my sellers are pros. And, as you would expect, we’ve seen plenty of action.)

Why  should prices decrease when interest rates increase? There are a number of reasons, but here’s how I like to think about it:

  • Properties are ultimately valued based on the cashflow they generate for their (prospective) buyers
  • Higher interest rates mean higher debt payments, given the same loan size
  • High debt payments mean less free cashflow left over for the buyer
  • Less cashflow left over for the buyer implies a lower return on the downpayment she has invested
  • Assuming the buyer is seeking a certain minimum percentage return, the only way to get there is to lower the price (and thereby reduce both the amount borrowed and the downpayment)

So, when interest rates go up, you should expect prices to go down.

My broker friend explained that this does happen, but usually only after a few months with very few transactions. This is because:

  • Buyers immediately get the memo about higher interest rates (they hear it directly from their lenders), and therefore adjust what they are willing to pay;
  • Sellers don’t get the same feedback (they typically aren’t speaking with any lenders), so they are much slower to adjust the amounts they are willing to accept;
  • So, nothing happens until sellers get the memo (due to getting only low-ball offers or, indeed, no offers) and reduce their prices.

That’s what’s going on right now, and I expect it will continue for several months. Meanwhile, I’m probably going to be the guy low-balling sellers.

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