Last week, I wrote about a scenario where a venture owns a home worth $500K outright. And then I played with various scenarios on debt issuance, dividends, and stock buybacks to show how stock buybacks may actually be eroding value for remaining shareholders especially if the buybacks are just being done to neutralize employee stock option issuance.
I'd like to use the same scenario to illustrate what happens in a changing interest rate environment like we are in now. Let's start by assuming the same $400K loan on the $500K home at an interest rate of 3%. This is not far off from what mortgage rates were a couple years ago and also what the average corporate bond rate was at when the risk free Treasury rate was around 1%.
Now, for this scenario, we need to assume the home is rented out and generates income. Let's use a 5% yield on the $500K value. This equates to a P/E multiple of 20 (1/.05) which is about what homes and stocks had been valued at in a low interest rate environment. A 5% yield means the income is $25K per year. When you factor in the interest expense of 3% on $400K which is $12K per year, this leaves cash flow for the shareholders of $13K. This means their $100K of equity is generating a 13% return per year, a pretty decent return and aligns with what most investors had been getting in a low interest rate environment.
But now let's assume mortgage interest rates change to 7% like they are currently. This also happens to be about what corporate bond rates are at now with the risk-free Treasury rate at 5%. This means the $400K loan costs $28K in interest but that exceeds the current income of $25K. Therefore, $500K is no longer a reasonable value for the home. All the equity has been wiped out since there is no profit left over for them. This doesn't mean the home has no value, just there is no remaining share value for equity.
How do you figure out what the home is now worth? That is where the weighted average cost of capital (WACC) comes in. If (1) a loan has an interest rate of 7% and a lender will lend 80% of the value and (2) equity requires the same 13% return as before for the remaining 20% of value, then the WACC is 7%x80%+13%x20% = 8.2%. This is the new all-in yield that is required. If the profit from renting the home is still $25K, then the new value is $305K. Geek's note: you can check the math by first calculating the loan amount at 80% of the new $305K value which equals $244K. This leaves $$61K of equity. The $244K loan has an interest cost of $17K at a 7% interest rate. Remaining income for equity is then $8K which generates a yield of 13% ($8K/$61K).
Take a moment to see what this math yields. A home that was worth $500K in a low interest rate environment is now worth $305K in today's higher interest rate environment. And this is based on the assumption that equity is still happy with the same 13% return as in the low interest rate environment. In all likelihood, they now demand a higher return since the risk free Treasury rate is now 5%, not 1%. The required return on equity is more likely to be 20%. If that is the case, the WACC is 9.6% (7%x80%+20%*20%) and the value of the home is $260K. Using the value range of $260K-350K, this means the value of the home is 40-50% lower than it was in a low interest rate environment.
Both the real estate market and the stock market have not yet accepted this new reality. Both are betting on lower interest rates to come to support current values. But if the Fed holds interest rates higher for longer, then eventually things will get repriced. We may be seeing the beginning signs of that now.
The other reality is with lenders. Recall there was an original lender with a loan of $400K, but the home is now only worth $305K or perhaps even lower. That means the lender is facing a loss of $95K or more. This is a very simple example of an incredibly complex financing system but this type of scenario is playing out right now. Banks and their depositors are not able to absorb these kinds of loan losses nor is equity accepting the fact that they may have no equity. The system is now officially bankrupt and there are two choices forward: (1) either investors, lenders, depositors, and every other person in the financial food chain accept the losses facing them or (2) the Federal Reserve and Federal Government are required to issue bailouts like they've done in the past. We'll see which scenario plays out. The statistic to watch is the overall economy reflected by the $25 of net income that the hotel generates. If the profit generating fundamentals of millions of business start to deteriorate, it will exacerbate the fall in values and trigger a deflationary feedback loop. This is what happened in the beginning of the Great Financial Crisis before the Fed and Federal Reserve stepped in to provide support and bailouts. It may require such extreme measures again.