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Commercial Real Estate
Westlake Village
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Address
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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."
Credit Dislocation Hits Commercial
Sector
September 21, 2007 - September 27, 2007
Provided by Commercial Real Estate Direct
Credit-market dislocation has impacted capitalization rates in the multifamily
and office sectors, reports Reis Inc. Capitalization rates during late July and
August dropped 30 basis points in the multifamily sector and 10 bp for office,
according to Reis' latest report on credit market conditions. Late July into
early August is when the commercial real estate investment market started
feeling the full brunt of the credit market turbulence, in which lenders pulled
back from the market, causing deals to be re-priced or cancelled altogether. The
New York research firm further indicates that credit turbulence has caused a
decline in investment activity and moderation in price appreciation.
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