It’s Bill Rapp, the Mortgage Viking here, let me tell you about what the Good Ole Boys on Wall Street are talking about today…
The commercial real estate market has enjoyed more than eight years of development growth and improving prices. Increasingly, investors and lenders are asking if we are near the end of this long cycle, or if future growth expectations can maintain values.
My expectation is that capitalization rates will shift slowly higher over the coming year, but movement will be mixed and influenced by interest rates, cycle position and expansion pace.
Capitalization (cap) rates have long represented a measure of asset value. When cap rates are low, values are high (see example to the right). A critical part of any commercial real estate sale transaction is interest rates, as required short term and long term returns are often a product of the risk-free Treasury rate plus some risk premium. Given, interest rates are expected to rise over the next 24 months. Will this presage a loss in asset value?
Theoretically, as interest rates creep up, so should cap rates. Makes sense, but there is seldom Treasury Bill (or even a clear) correlation in the real world. For instance, in July 2016, the 10-year spread was 137 basis points. Since then, the long-term rate has moved significantly higher, but cap rates have shown little movement. What happened? A number of factors played a role, however, from the interest rate perspective, the quantitative easing program employed by the Federal Reserve continues to influence the 10-year resulting rate. My expectation is that easing rates could have little impact on cap rates until the treasury rates move back well above 3.25%. As rates progress beyond 3.25%, the connection will reengage and capitalization rates will become considerably more sensitive to rate increases. An additional impact may come from the reduction of the Fed’s balance sheet, however, this will have a slow, but continuing impact, given the gradual pace of the unwind.
The commercial real estate property markets continue to perform well. Peak occupancy levels are coupled with moderate rent gains that are driven by the continued health in the overall economy. However, there are concerns regarding the length of the expansion and the commercial real estate industry position in the cycle. While healthy performance continues, there has been a leveling of effective rents. Additionally, concerns related to corporate debt levels, trade wars and inflation create concerns around the economy and further considerations for commercial real estate. If these cooling trends all come to fruition at the same time, in concert with rising interest rates, then the possibility of higher cap rates and lower asset values becomes more probable.
Commercial real estate has also benefited from a slow recovery. In faster growing economies, expansion levels typically create higher yielding investment alternatives, which often move capital to other assets classes.
However, the present environment creates a measured expansion that continues to grow slowly and limits the number of higher yielding alternatives.
Of course, there are many influences on cap rates other than interest rates, including:
- The Tax Cuts and Jobs Act has generally created favorable treatment for commercial real estate, which benefits valuations.
- Foreign investment appetite, trade pressures or other factors influencing demand for U.S. Treasuries can also have an effect. If China or Japan were to materially decrease their holdings in U.S. Treasury, the underlying interest rates and cap rates could be affected.
- As a hard asset, commercial real estate often maintains a value floor during recessionary conditions.
Current economic conditions remain positive for commercial real estate. While potential headwinds are apparent, our expectation is for continued slow and steady growth in the economy. The ongoing expansion will continue to accommodate steady performance and investment opportunities in commercial real estate industry, which will support current valuation levels. The most relevant valuation concern is around interest rates. As the 10-year Treasury rates have moved back near 3.25%, we should see capitalization rates reengage slowly at first then more proportionally as rates move further from their current level. Nonetheless, if the pace of increase remains measured and the economy healthy, we expect rent growth to offset most of the increase in the capitalization rates.
Impact by sector – Multifamily
The apartment sector has enjoyed strong demand during an eight-year period of recovery and expansion. As the sector continues to mature through the cycle, concerns related to supply levels and rent acceptance have emerged. However, investors are seeing through the temporary imbalance. As a result, multifamily should continue to perform well — driven by continued demand for the product. Supply is a short-term issue — there will be some disequilibrium in certain markets, but it will not be broadly observed. Overall, we should see cap rates steady to slightly lower in this segment.
Impact by sector – Office Sector
My expectation is that cap rates in this segment will remain flat with a slight upward bias. Employment rates will affect this market, as will the move toward more telecommuting and remote work and the resulting need for less office space. Additionally, there will be more employees per square foot in newer office buildings.
The office world is a little like the retail world in that office buildings in vibrant locations, with lots of density and attractive amenities, will be desirable and command lower cap rates. Those in more remote locations will be penalized with higher cap rates. Rent growth may be sufficient to offset interest rate increases. However, this sector remains dependent on economic health, and cap rates will bump up fast if the economy falters.
Impact by sector – Retail
At 24 square feet per capita, retail space in the United States is much higher than in other country. This segment is also facing headwinds as a result of e-commerce and an aging business model.
Overall, the expectation is that cap rates will move higher, but there are exceptions. Class A properties that are well-positioned demographically will retain their value and values may increase. Malls, Power Center and other products in the B to C sector will see substantially increased capitalization rates as values are expected to decline.
Impact by sector – Industrial Sector
As the retail world has changed, it has created demand for new, efficient, well-located industrial space. Retailers have to be more efficient at shipping and receiving. They need to deliver faster and more reliably, so they migrate to good locations close to customers. As a result, valuations are remaining solid and cap rates are decreasing for distribution centers.
For example, a major U.S. hardware manufacturer has maintained aging warehouses in areas where they have most of their retail outlets. Now they are consolidating distribution into a one million square foot warehouse that will enable them to assure their customers that they can take orders and deliver goods within 24 to 48 hours.
Impact by sector – Hotel Sector
This segment is maintaining last year’s occupancy levels and perhaps even expanding a little. Valuations are remain high, but the outlook is flat. Due to the robust economy, there is enough travel activity to make this segment viable. Still, most markets have as many rooms as they need.
If business conditions cool, the effect on the hotel industry can appear quickly. The market is cautious and if there’s a sign of economic contraction, those who were cautious could become quite conservative.
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