What does demise of Silicon Valley Bank mean for real estate?

As 2022 began, the yield on 10-year Treasuries was 1.73%. Also referred to as T-bills, their going rate today is 3.4%.

Last week the rate eclipsed 4% for the first time since last October. But before all that, rates had stubbornly refused to budge north of 4%.

During the Federal Reserve’s loosening in the pandemic – rates on 10-year Treasuries were below single-digits. That’s right! In mid-2020, if you agreed to tie up your money for 10 years – until maturity – you’d receive a paltry 0.52%.

Let’s say you were quite cautious, aka risk-averse, but wanted some return on your cash and bought a pile of these government issues. If you planned to redeem the bonds in 2030, no problem. The return would be there, along with your principal amount.

Let’s say, for example, you parked $100,000 in T-bills. You could expect your investment to yield $520 per year for its duration.

But .. What would happen if you needed the principal before the maturity date of 2030? You could sell the bonds on the market — at a steep discount. How much, you may be wondering? Using the yield of 3.4% today, your principal would be worth $15,294! That’s a hit of close to 85%.

This very over-simplified example is partially what caused Silicon Valley Bank to fail and be seized by federal regulators. When the run on deposits occurred last week, the bank was forced to take a loss on its bond portfolio in order to cash out investors.

Bonds move inversely. As the price of a bond increases its yield decreases and vice versa. Capitalization rates on real estate behave in a similar fashion. As cap rates increase, the value of the underlying property decreases.

So, this all begs the question: What impact does a bank failure have on commercial real estate?

Rate hikes tempered

When the central bank started its march toward a federal funds rate target of 6% — in an effort to lower inflation to 2% — a series of 0.75% rate hikes ensued. These rate increases then shrank to 0.25% rate increases early this year as inflation showed signs of easing.

We’ve now experienced a couple of months of strong job numbers paired with increasing wages and a resilient consumer who refuses to stop spending.

Before the bank shenanigans of last week, many believed a 0.5% increase was in the works for the Federal Reserve meeting in March. However, because of the rapid increase in the Fed Funds rate (remember, we’ve gone from half-a-percent to 4.5% in less than a year), some believe we could avoid an increase altogether.

Borrowing costs rise

If depositors believe certain banks are riskier than others, they’ll demand a greater return on their money for the added risk. Read: Higher depository costs. If failures cause a revamp of banking regulations — similar to what we experienced in 2008 — reserve requirements might increase. The impact of these would mean fewer, more expensive dollars to lend.

Investments may slow

We saw a dramatic decline in institutional investor activity in the second half of 2022, falling mostly to private capital investors. Historically, this investor genre will pay less than institutions.

Primarily it’s because they borrow money to affect the buy. A classic disconnect is now occurring between buyers and sellers. Unless there is distress on behalf of a seller and/or tax motivation on behalf of buyers, the dance ends before the band tunes up. I don’t see this ending soon.

Cap rates may be higher

Expect higher cap rates because of all of the above. Keep in mind: A year ago 3.75%-4.25% cap rates were the norm. Traditionally reserved for the bondable absolute net investments — such as Amazon on a 10-year lease with 4% annual rent hikes — capital, seeking return, was pouring into anything with a truck door.

Many eschewed long-term leases in favor of shorter terms where a rent pop could be sooner realized. Nowadays, the government will pay you 4.2% for a two-year Treasury backed by the full faith and credit of the United States.

Sure, you don’t get the appreciation or depreciation of a real property investment but the risk is minimal.

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104.

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