Commercial Real Estate Finance

Reuters reports that two-year notes sold by Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity. In school I learned that investing in international real estate is risky because of differences in property rights; political risk including layers of taxations; and financial risk such as foreign exchange risk. There are several ways one can try to adjust account for international investment risks. One way is to use the adjusted NPV model proposed by Hayden and Musa (1990). Unlike the standard DCF model which discounts the cash flows by the discount rate, the international DCF model multiplies the Cash Flows by the Forward Exchange Rate in the numerator, and uses a discount rate that incorporates political risk, labor risk, and un-hedged currency risk.

This model was originally implemented because international investing was more risky than investing domestically because of the added political risk. However, with the CBO estimating that publicly held debt will balloon to $20.3 trillion, or 90 percent of GDP by 2020, US Treasury yields indicate that investors view the US to be more risky than many blue chip companies, and several foreign countries. Bloomberg reports that:

“Investors demand 0.60 percentage point more in yield to own 10-year Treasuries than German bonds of similar maturity, Bloomberg data show. A year ago, debt of Germany, whose deficit is 4.2 percent of its economy, yielded about half a percentage point more than Treasuries.”

It is conventionally thought that as the spread between U.S. Corporate Yields and Treasury Yields narrow, it is a sign that confidence in business is improving. However, in this case, it seems that the narrowing of the spreads, to the point that Corporate Yields are lower than Treasury Yields, indicates a weakening in the confidence of the U.S. government to meet its obligations.

The Green International DCF model mentioned above can be used to value real estate investments in different countries. The denominator requires a political risk factor. U.S. political risk relative to Sovereign Country X is somewhere between the difference between the Corporate Bond Yields in Country X and Treasuries (upper boundary), and the difference between Corporate Bond Yields in Country X and Corporate Bond Yields in the US (lower boundary).

Y_corp.x – Y_Govt.U.S. = Upper Bound Spread

Y_corp.x – Y_corp.U.S. = Lower Bound Spread

The robustness of the commercial real estate industry and its ability to recover from the economic recession relies on foreign investors buying US real estate. Increases in the US Treasury Yields indicates increasing political risk for international investors, which increases the discounting effect and lowers the value of US real estate because investors require larger returns to be compensated for the increased risk. Rising Treasury yields is bad news for owners of US commercial real estate.

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