|
Exclusive Listings by Lloyd
Wertheimer
|
Commercial Real Estate
Westlake Village
Telephone
805.497.4557
FAX
805.496.3589
E-Mail Address
Lloyd@Westcord.com
Address
951 Westlake Blvd
Suite 101
Westlake Village, CA 91361 |
| |
Falling Cap Rates Hit the
"Red Zone"
Written by Tim Trainor
With Cap Rates Having
Fallen About as Low as They Can Go, Investors Must Be
Prepared To Alter Buying Strategies
The spectacular rise in property values
that has largely fueled the buying frenzy within
commercial real estate over the past three years has
resulted in investors flipping properties for big gains,
in many cases after buying and holding them for just
months instead of years.
At the same time, a new report notes, cap rates for
almost all property types have been doing the Limbo, and
now they've gone about as low as they can go.
Investors and underwriters alike are alarmed at how far
cap rates have fallen, driving returns into the "red
zone," the point where the spread between purchase cap
rates and 10-year Treasuries falls below 250 basis
points.
At this level, Dennis Yeskey of Deloitte Consulting
points out, there is no room for error, as real estate
values may no longer generate a viable risk-adjusted
premium over the cost of borrowing money.
"If an investor is buying a building today at a 5.5 or 6
cap rate and thinks he or she is going to sell it next
year at a 4 cap rate, they're in for a rude awakening,"
notes Yeskey, national director of Deloitte's Real
Estate Capital Markets group and principal author of the
firm's 2006 Real Estate Capital Markets Industry Fall
Update. "Right now, you need to be very careful you're
not overpaying, because increasing property values
aren't going to bail out investors who overpay.
"They're going to have to look at the underwriting and
see where they can either fill vacant space or increase
rental rates in order to get the returns they want. In
other words, they're going to have to earn returns the
old-fashioned way," he added.
The good news, Yeskey said, is that cap rates are
finally flattening out.
"They couldn't go much lower. And investors get that;
they realize they shouldn't be buying buildings at such
a thin spread. Real estate is not a liquid asset, there
should be a risk premium over Treasuries."
As a result, Yeskey believes, we'll see less churning
going forward and more investment based on the potential
for deriving revenue from raising rents and operating
buildings efficiently rather than from cap rate
compression.
From a macro perspective, Yeskey said it couldn't happen
at a better time. "It looks like we may time this just
right, if fundamentals hold. We're in really good shape
in terms of supply and demand. There hasn't been a lot
of new construction. That may be changing, but right now
we're seeing a nice return in demand. Rents have started
to move up in most markets, which is very good news for
investors. And in some, like Midtown Manhattan, you're
seeing rent spikes of 15% to 20%."
Yeskey said commercial real estate markets haven't
always fared so well in the past.
"Usually, when cap rates get this low, alarm bells go
off," he said. "Every time in the past 30 years that
we've pushed cap rates down near Treasuries, it's the
old story: 'Houston, we have a problem.' "
This time, the industry responded quickly and didn't
keep developing when rents were falling and market
fundamentals were going down. Yeskey said there are
several reasons to account for this.
"First, there's a lot more discipline among lenders and
investors. And quite frankly, there's a lot more
information available now to make better decisions. You
also have to factor in construction costs, materials and
supplies, which have soared (in cost) over the past few
years. That created further friction that limited new
development. And you can chalk up some of it to
increased government oversight. In certain areas,
instead of taking two years to gain the necessary
approvals and put up a building it may take three or
four depending on the level of scrutiny and approvals
needed."
The ability of the industry to keep market fundamentals
in check is a big reason why commercial real estate has
been, and continues to be, among the best-performing
investments. Returns have exceeded almost every other
investment option over the past five years, and appear
likely to continue on that trajectory into 2007.
"We've seen an unprecedented flow of capital into real
estate, well beyond anything we predicted for 2006,"
Yeskey said. "You see funds forming left and right as
investors line up in search of returns that only real
estate has delivered recently."
If there is a dark cloud on the horizon, Yeskey said it
would be the increasing debt levels creeping up across
all property types. Debt offerings are increasing in
size and in number, while debt service coverage ratios
are dropping.
"People are really starting to leverage up and the
competition is such that we're starting to see
underwriting standards sag," said Yeskey. "If there is
one big area of concern it would have to be the dropping
debt service coverage," Yeskey noted. "That ratio was as
high as 1.5, but even as rents have risen, the average
ratio has dropped down to 1.3. People are leveraging up
properties more, debt service is higher, and that means
they have less of a cushion should there be a downturn."
With no end in sight to the amount of capital in
competition for real estate deals, Yeskey does not
foresee a pullback or curtailment of investor activity
in real estate any time soon. Rather, the search for
yield is driving more investors to look in smaller tier
markets and invest in smaller sized buildings and to
seek out property niches that may generate the types of
returns they've enjoyed in the past.
"There's still a lot of money coming in and it's got to
find a home. We're seeing a lot of interest among
investors in so-called niche-plays, things like
healthcare facilities, medical office buildings or even
student housing. We think we'll see more investors start
buying infrastructure, things like airports, toll roads,
tunnels and bridges. There's been more of that overseas
but we think it will catch on here as well."
"Of course, you'll still see a lot of investors still
clamoring for the core, stabilized properties, buying at
5.5 to 6 cap. They may not see a lot of yield, so
they're going to have to work to increase rents. And
that means they'll be holding onto properties longer,
waiting for the rents to roll over and lease it up at a
higher number. In many ways, investors are going back to
basics."
|
