Interest Rates, Cap Rates and Commercial Real Estate Values

CRE Finance World, Summer 2013

Interest Rates, Cap Rates and Commercial Real Estate Values What will happen to CRE valuations when interest rates begin to rise? Brad Doremus A publication of Summer issue 2013 sponsored by CRE Finance World Summer 2013 35 ommercial real estate as an asset class was not alone in its decline during the downturn of 2008-2009, as investor sentiment turned overwhelmingly risk-averse and liquidity dried up. As the economy recovered, commercial real estate valuations rose as cap rates fell. By late 2010, cap rate levels had declined significantly. Several factors contributed to this recovery, not the least of which are the low interest rates supported by the Federal Reserve. The question now is how cap rates and commercial real estate valuations will fare, once interest rates begin to rise. Selection Bias, Cap Rate Confusion and Valuation Consider the charts below and the divorce between trends in fundamentals and cap rates. The chart on the left indexes vacancy rates for the multifamily, office and retail sectors from the beginning of 2006 until the end of 2012. There is clearly a discrepancy in inflection points and recovery rates, with multifamily leading the way in terms of occupancy improvements. Office and retail vacancies have begun to recover over the last five to six quarters, but at a much slower pace. Contrast this with the chart on the right, which illustrates how cap rate levels across property types have descended to levels last observed in 2006. This sharp reversal is understandable for the multifamily sector, which has seen national vacancy rates decline to 4.3% by the first quarter of 2013 — a level unseen in more than a decade. But why are office and retail properties being valued so highly when fundamental drivers of net operating income have not bounced back in any material fashion? Figure 1 Source: Reis, Inc. Figure 2 Source: Reis, Inc. The answer is selection bias: vacancy rates are calculated for all available properties, while cap rates can only be calculated for buildings that transact. And although transaction volume has risen since 2009, commercial real estate sales activity has yet to approach peaks observed in 2007 (transaction volume is still down about 70% from 2007 annual figures). This means that the decline in cap rates is being driven by a select group of properties, mostly Class A buildings in gateway markets. The proverbial tail is wagging the dog, with marginal cap rates suggesting robust increases in valuation. If we accept the proposition that low interest rates have driven yield-hungry investors to real assets like commercial properties, what is going to happen when interest rates begin to rise? When do we expect interest rates to rise anyway, given the glacial pace of global economic recovery? Will cap rates across markets react in the same fashion, should the Fed begin ratcheting up interest rates? Interest Rates and Valuation Like any other asset class, the valuation of real estate is based on the discounted cash flows that a building is projected to produce. The general assumption is that as interest rates rise and fall, the discount rate that is applied to buildings also rises and falls, causing commercial real estate values to behave like most other asset classes. However, an empirical examination reveals that this assumption is not patently true. Interest rates tend to rise and fall based on the economic environment — when the economy is performing well, interest rates tend to rise as investors sell out C Associate Reis, Inc Michael Steinberg Senior Analyst Reis, Inc Ryan Severino Senior Economist Reis, Inc


CRE Finance World, Summer 2013
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