Wayne Gretzky’s famous quote, “I skate to where the puck is going to be, not where it has been,” is as applicable to real estate as it is to hockey.
A forward-looking view is beneficial when it is grounded in empirical data that offers predictive power. To that end, we find that leading economic indicators provide helpful clues about real estate performance and investment opportunities.
One such example is the yield spread between the 10-year Treasury bond minus the three-month Treasury bill (see chart). The yield spread is practical with frequent observable data points and has been found to be a good predictor of future economic growth. The tendency is for the yield spread to widen in advance of economic expansion. Conversely yield spreads tend to narrow or even invert prior to a recession. Specifically, what does the yield spread tell us today and how can we use this information moving forward?
As the chart illustrates, the yield spread between the 10-year Treasury and the three-month T-bill was 2.01% as of March 2015, slightly above the long-term average. This would suggest the probability of a recession is very low – which, of course, it is. The Federal Reserve Bank of New York uses the yield spread to calculate the probability of a recession in the U.S. Currently, their model predicts a mere 3.55% probability of a recession over the next 12 months.
Yield Spread as it Relates to Apartments
The yield spread between the 10-year Treasury and the three-month T-bill contains at least three important pieces of information for the apartment market.
- First, economic activity is an important indication of future tenant demand. (No surprise here.)
- Second, based on the chart below, yield spreads tend to lead apartment demand on a historical basis. If the relationship holds, the current downtrend in the yield spread warrants some caution.
- Third, the yield curve has implications to mortgage rates, which can potentially impact cap rates.
In conclusion, the yield spread has provided an important forward-looking indicator on a historical basis. One could argue the yield spread is not as effective during a zero interest rate environment, but understanding the correlation gives investors another piece of information for decision making. Furthermore, with the Federal Reserve set to raise the federal funds rate later this year – in addition to foreign and domestic capital flowing into the 10-year U.S. Treasury – the yield spread could compress in the coming months not from to economic distress, but from the nature of capital flows in a global economy. Moving forward, even with potential false signals, the yield spread offers business intelligence and provides a forward-looking indicator for real estate investors to avoid being cross-checked by an economic slowdown.
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