An overview of how a shifting economy and inclining interest rates will impact commercial real estate in 2017.
In our last post we summoned the bear in us to rail on the Fed for its flagging credibility stemming from its lack of courage to shift to a tighter monetary policy.
The bears wonder when Ms. Yellen & Company will finally run out of excuses for perpetuating their cheap money stance, which has painted the central bank into a corner it can’t get out of without inflicting serious pain on all of us.
Yet, there is no denying that some measure of pain will be the consequence of a decade’s long experiment in rates at the zero bound. While the Bears would rather take their medicine now in hopes of less pain, the Bulls still like the cheap money and hope the Fed takes its time and finds more excuses to maintain the status quo. They choose not to think about pain until they actually feel it.
After hinting, suggesting, and hedging for a full year, our fearless central bankers finally stepped up and increased the benchmark Fed Funds Rate by 25 basis points to .75%.
While most experts were expecting the move and market reaction was mostly baked in, the very fact that Ms. Yellen and her Federal Open Market Committee actually made the move is significant. They have given every excuse they could think of over the past four quarters to leave their foot on the gas, but running monetary stimulus at full throttle has left little room to respond to an economic slowdown that many feel is looming.
The economy has been in a technical recovery for over 7 years, but it has been anything but robust. GDP growth is languished at the 2% level for the past few years and too many of the millions of new jobs created during the recovery have been at the lower end of the wage scale.
The U-3 unemployment rate (the one we hear about every day) is now under 5%, but the U6 rate, which includes the ranks of the “under-employed”, just recently fell below 10%. Wage growth has been weak and the Labor Participation Rate, which measures the percentage of those eligible for work actually in production, remains in the 63% range.
That’s not much to celebrate.
Assuming rates will keep moving higher, we now look at the potential impact of the rising cost of money as it relates to commercial real estate. Even the bullish of Bulls will admit that a higher cost of capital will not go unnoticed.
The relationship between cap rates and the interest rate on debt is undeniable. Smart investors don’t purposely buy property at 5% cap rate and borrow money at 6%.
Negative leverage is not a good thing. Period.
But, for the past few years, cap rates have been compressing, and depending on product type and market, going-in cap rates are in the 4% to 6% range. While there are several reasons for the compression, the main one is cheap debt. Even if you have to buy at a 5% cap rate, but you only have to pay 4% for your debt, leverage is positive. That is good thing. Period.
So, with those simple facts in mind, you would think everyone would assume that cap rates will decompress accordingly as soon as the cost of debt moves higher. Hard to argue with that logic, but the Bulls find a way.
They see vacancy rate declines, positive net absorption, rising rents and a lack of new inventory as reason enough to think that the bull run in commercial real estate is far from over.
In major markets like Southern California that are nearing full buildout, the cost of remaining land is prohibitively expensive and that adds value to existing properties, as they are becoming irreplaceable. To Bulls, the value of irreplaceable assets can only go up over time, and, they do have a point. The supply/demand balance is still way out of whack.
Too much money is chasing too few deals and that perpetuates competition for quality assets.
Investors of all kinds are tripping over each other to be the winning bidder, and are quick to bust out the bubbly even if they have to set a new record-high price to do it.
Institutional buyers, foreign buyers, local investors and owner/user buyers keep snapping up anything that doesn’t have wheels just to get in the game. Yes, investor/buyers know prices are high, but they think a 5% return on a tangible asset like commercial real estate beats a 1.7% return on a 10 year T-bill. That 5-cap can has a chance to move much higher as rents move up and vacant spaces are filled.
In short, they are willing to pay the premium because they see upside potential that will mitigate the risk associated with the spread between cap rates and interest rates. Also, if they can grow net operating income, that helps offset the impact of having to exit the investment after cap rates finally decompress.
Risky? Yes, it is, especially if your exit strategy is not long term enough to ride out a market correction.
The Bull who pays the price for a quality asset with good credit tenants on longer term leases sees himself in a pretty good position. He can collect his rents with minimal risk of high vacancy or credit loss and bridge the gap to the next market peak. If he’s a leverage guy, then he can borrow long term with 4% debt and reap the benefits of positive leverage.
For owner/user buyer Bulls, it’s not just about buying irreplaceable assets. It’s also about controlling occupancy cost and leveraging with low cost debt. Using SBA financing, owner/users can put just 10% down and finance 90% of asset value with a fully amortized loan in the 4% range. They like the idea of capping one of their biggest operating expenses while they build equity with every monthly payment.
This combination of high leverage and low interest is absolutely compelling, especially for those with a bullish mindset. So, it’s no wonder that owner/user properties have seen double-digit price appreciation for several years running.
The Bears are concerned that the normalization of interest rates will mean the normalization of cap rates, which are historically much higher than they are today. The math is scary. If the market cap rate for a property purchased at 5% cap rate rises to 6%, that property is worth 20% less, assuming the same level of net operating income. No one can say that the spread between cap rates and interest rates will move in lock step, but the correlation between the two will most certainly be positive.
Owner/user deals are less cap rate sensitive because the underlying motivation to acquire property is different. They are hybrid deals that are less than arms-length in terms of the ownership structure.
Typically, the owner of the business is the legal owner of the property, and his or her company becomes a tenant. The benefits of ownership can be allocated based on which entity they impact most. Often, owners charge in rent what they pay in debt service, and then utilize the tax benefits of ownership to protect their personal incomes.
When owner/user deals are sold, they are sold as empty buildings to another owner/user. So, cap rate compression and decompression is not much of an issue. However, prices can move up or down quickly as interest rates change. When interest rates rise, it raises “occupancy” cost and demand decreases, causing prices to decline.
When rates are low, long term occupancy costs can be fixed a lower level and demand rises, creating more competition and higher prices. This is the current state of the owner/user market. The Bears say current owners should sell now before rates rise and prices decline. In other words, get your chips off the table before the dealer finally wins a hand. You get the picture.
Next week, we will take a look back at 2016 from a commercial real estate perspective and offer up some thoughts on market direction during the first year of the Trump Presidency.