Economy Watch: Will the Rate Rise be the Pin That Pops the CRE Bubble?

By Dees Stribling, Contributing Editor

Now that an interest rate increase is a near certainty next week, worries about its impact on commercial real estate are coming to the fore. The thinking is that all it might take is one little prick (namely, the small rise in rates) to pop the commercial real estate bubble, if there is a bubble. After all, bubbles have a history of reacting to relatively small stimuli in outsized ways, rarely in a positive way. The 19th-century writer Charles Mckay, who wrote about mass manias (such as the tulip mania) with some flair, pointed out that, “Men [people, in modern terms], it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” Has CRE been moving in that kind of herd?

There’s no doubt that commercial real estate prices have increased dramatically in recent years. Recently Green Street Advisors released its latest monthly report on valuations, and the upward trend hasn’t abated. For November, the company’s U.S. Commercial Property Index was up 2 percent; for the year, property prices were up 10 percent, or about the same increase as the market enjoyed in 2014. The index now stands at 122.7, well past the previous peak just before the recession of 100. The recessionary through was 61.2 in early 2009, so the index’s climb has indeed be spectacular over the last five years.

“Cap rates have been holding firm, and in some instances, even moving lower as investor demand for commercial property remains strong,” Peter Rothemund, senior analyst at Green Street, noted. “The question is whether that trend will continue. Cap rates look low when they’re compared to corporate bond yields. Said another way, properties look expensive. If this isn’t the peak, we’re probably close.”

Talk about the peak will only be confirmed in hindsight, but there’s still a lot of talk about the peak right now. Take New York City as an example (and a good one, considering its size and how much commercial values have increased there in recent years). Last week Marks Paneth released its fall 2015 survey of New York City commercial real estate executives (completed in October), which found that a large majority (71 percent) of them say values have now peaked, compared with only 54 percent who said this in the last survey, several months ago. Moreover, 66 percent of executives say New York real estate is, at its current level, overvalued compared to property in other major global cities.

Will an interest rate hike pop that bubble? Maybe, say the respondents. Forty-six percent say values will decline if the Fed raises interest rates, while 35 percent say they’ll stay the same, with 13 percent saying they don’t know. The 109 professionals participating in the survey, according to Marks Paneth, include owners and managers of commercial property, commercial real estate brokers and agents, attorneys, accountants and other professionals specializing in the sector.