To truly understand what is going on in the real estate market, you first need to understand the relationship between real estate values and interest rates. Real estate is an asset that has what is referred to as a fixed income stream. A fixed income stream is a relatively predictable amount of cash year in and year out. If you are an owner of an office building and your tenant has a 10 year lease, you know what you should be getting paid in rent over the next 10 years. These locked in cash flows are the fixed income stream real estate produces. Here is what Sternlicht meant when he said any asset with a fixed income stream decreases in value as interest rates rise.
Real estate is what economists refer to as a commodity. The price of any commodity is dependent on the supply and demand dynamics at that given time. We know from earlier that the value of the building is dependent on the cash it generates. However, what determines what rent you as the owner can charge for each of those units? It’s the supply and demand of apartments within that particular real estate market.
For owners of the apartment building, so-called “strong fundamentals” is when demand outstrips supply. Over the past few years, the economy has been extremely strong. Unemployment was low and government stimulus programs were high. Add to that the fact that home prices skyrocketed, forcing many would be home buyers to stay renters. These factors caused demand for apartment units to increase, pushing our demand line here out to the right. Notice how the supply and demand line now cross at a much higher price. The higher rents increased the cash apartment buildings generated, making them even more valuable.