By Paul Fiorilla
Commercial real estate has had an almost uninterrupted run of increasing values since bottoming in the wake of the global financial crisis in 2010. Acquisition yields have persisted at historical lows for several quarters, and many question how long the asset class can remain priced to perfection.
As we head into 2017, a potentially bigger impediment has emerged: rising interest rates. The 10-year Treasury rate increased more than 65 basis points between the election and Christmas as investors react to the prospect for more robust domestic output during a Trump’s administration, the potential for reduced oil output and more aggressive monetary policy by the Federal Reserve.
Since the 10-year government bond is the benchmark used in the commercial real estate market for pricing debt and equity, it stands to reason that the cost of owning properties will rise, and lead to an increase in acquisition yields (otherwise known as capitalization rates, or cap rates). That, in turn, could reduce the value of individual assets.
Of course, pricing real estate is not that simple. Values are derived from a combination of income, expenses (such as debt) and the sentiment of investors, which is expressed in the premium between the risk-free rate (10-year U.S. Treasury) and the return buyers are willing to accept. Even if rising rates leads investors to demand higher yields, income growth and bullish investor sentiment could minimize the effect on property values.
Investors Cautious After Long Period of Rising Values
Since dropping 40% during the global financial crisis and bottoming in January 2010, commercial property prices have risen by 103.5%, according to the Moody’s/Real Capital Analytics Commercial Property Price Index. Multifamily values have risen by 140% during that time and other major property types a combined 90%. The rebound was driven by the combination of strong rent growth, low interest rates, which have reduced financing costs, and bullish sentiment – in other words, buyers are willing to accept low yields because they are optimistic about the safety and performance of the sector and have few better options.
Worries about the future direction of values rests on the proposition that the factors that produced outsized gains in values in recent years appear to be less favorable today:
- Weakening property fundamentals. Since the end of the last recession, rents have grown in all property types to varying degrees. Apartments have led the way, with rents rising 27% nationally since January 2010, according to Yardi Matrix, while other asset classes have seen lesser gains as occupancies slowly increase. Many expect rent gains to moderate, as construction has started to pick up again in segments that have seen outsized rent growth, such as high-rise apartments and office markets in core central business districts.
- Investors more cautious. Demand for relatively safe investments that produce steady dividends led to a huge increase in capital flows to U.S. commercial real estate in recent years, the so-called “Wall of Capital.” Demand for properties still strong, but investors have become more cautious due to worries about rising rates, the prospects for rent growth and whether the market has gotten ahead of itself and is due for a correction. Although pricing is holding up, the investor pool is shrinking, especially for premium priced assets.
- Interest rates going up? One reason cap rates have remained so low is the unprecedented period of low interest rates. So while property yields have been at a historic nadir for the last couple of years, the premium that investors receive over the 10-year Treasury rate has been abnormally high by historic levels. That’s not the case anymore. The average premium between the 10-year Treasury and property cap rates has fallen since the election to more “normal” levels (since the year 2000 it is roughly 365 basis points).
That could mean that if rates keep rising, cap rates may go up in sympathy, but not necessarily. Over the last 40 years, cap rates often drop when Treasury rates rise, because rates increase during periods of strong economic and rent growth, when investors are willing to pay up for properties in anticipation of rising revenue.
Capital Markets vs. Fundamentals
Today’s market provides a good lesson in the relationship between fundamentals and capital markets in determining price appreciation. Capital markets forces (interest rates and investor demand) appear to be a negative drag on prices while fundamentals continue to improve, even if the growth is decelerating.
To understand the relationship, Yardi Matrix did a study of how the values of different properties would be affected by increases in debt costs and property income. The study assumed that the cost of debt would rise the same amount as interest rates (in other words, the loan spread remained constant). When we maintained the same loan-to-cost and debt-service ratio on a property’s mortgage with no changes in revenue or expenses, a 50-basis point increase in the cost of debt produced a 35-basis point increase in the cap rate, which translates into a 5.8% drop in valuation. If debt costs rose 100 basis points, the decline in valuation increased to 11.2%.
The results were different when we added revenue growth into the mix. In that event, we found that moderate levels of revenue growth are enough to overcome low levels of interest rate gains, and strong revenue growth of 6.0% would be more than sufficient to make up for rate increases of 50 basis points.
Our (static) model found that a 50-basis point increase in the debt cost would cancel out a 5.0% increase in revenue. While it should be stressed that there are many variables that can change the results for individual properties, in general it is safe to say that revenue would have to grow at a fairly high level to make up for significant increases in interest rates. What’s more, as much as a model can provide statistical analysis, it can’t predict market sentiment, which is a significant component in transaction values.
Outlook For 2017
What does this mean for the market in 2017? Certainly the capital markets forces that have pushed prices up are running out of steam. Investors are wary about getting into bidding wars the way they have in recent years, and there could be a mismatch between buyer and seller expectations that could reduce transaction volume from very high levels of the last two years. That could mean fewer deals in core markets, where the spread between Treasury rates and acquisition yields has been paper thin, and more for secondary markets or value-add properties, where the yield premium is somewhat higher.
At the same time, demand for commercial assets should remain healthy due to strong job growth and demographics, and we expect moderate gains in rents. Multifamily rent growth will decelerate, and some markets will struggle, but overall we expect rent growth in most commercial property segments to remain positive. So while property values might decline as a result of higher debt costs and diminishing investor demand, rising property incomes will serve to maintain stable values or at the very least help to limit the potential damage to the downside.
A version of this content appeared in MBA Insights.
Image courtesy of Westwood Net Lease Advisors.