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CRE Finance World, Summer 2013

A publication of Summer issue 2013 sponsored by CRE Finance World Summer 2013 39 Divergences Explained With large diverse economies, large inventories, a pool of large sophisticated (often institutional investors), and greater liquidity, these metro areas tend to respond to changes in the capital markets to a much greater extent than their non-gateway brethren. Investors operating in these markets are much more cognizant of the changes in the economy and the capital markets and can quickly assess the implications for commercial real estate. The highly competitive nature of doing deals in these markets caused this information to be quickly and fully factored into valuation analysis and resulting cap rates. Market participants can see the translation from changes in the economy to the capital markets to fundamentals and risk premiums. Moreover, because economic activity in the US is so heavily concentrated in a relatively small number of major metropolitan areas, they stand to both gain and potentially lose more through different cycles of the economy. All of this results in a higher beta in these gateway metros, something that investors have anecdotally observed in the past. For the non-gateway markets, their relatively small size, more shallow and less sophisticated pool of investors, and poorer liquidity results in less responsive changes to the economy and interest rates. Even when the correlation is directionally the same as it is at the national level or for the gateway metros, the relationship is much weaker. With fewer investors, an absence of some of the most sophisticated investors, and poorer liquidity, these metros do not respond as quickly or as strongly to changes in the economy and capital markets. And because there is relatively less economic activity in these smaller metros, generally speaking they do not gain and lose as much through different cycles of the economy. These markets generally have a smaller beta. The Road Ahead With rising interest rates only a matter of time at this juncture, one must be careful about making projections based on historical observations. We are currently in a historically low interest rate environment. The Fed is aware that interest rates are artificially low and knows that they would be substantially higher than they are today if the economy were in a stronger position. Therefore, once the Fed feels that the economy can countenance higher interest rates, it is going to start raising them. Based on published Fed forecasts, the long-term “target” interest rate is likely to be 300-400 basis points above where they reside today, even if the pace of increase is initially measured. We have not seen that kind of upward movement in interest rates in the US since the early 1980s, before anyone was closely tracking commercial real estate, and certainly well before anyone was paying very acute attention to valuation and cap rates. However, what can we infer given recent trends? The current spread between cap rates and interest rates intimates that cap rates could have room to compress even as interest rates rise. What will determine this is the magnitude of interest rate increases. If there is a large upward movement in interest rates, it is probable that it will overwhelm the offset that we have observed over the last decade from improving fundamentals and strengthening investor sentiment. This means that if interest rates increase in a pronounced manner (i.e. 300-400 basis points), correlations with cap rates will likely turn positive. If interest rates rise in a less pronounced manner (i.e. 100-200 basis points), there is a higher probability that we could still observe negative correlations. What all this implies is that even if interest rates begin to rise, commercial real estate valuations may enjoy some breathing room before assumptions about exit cap rates need to be revised. It is likely that the Federal Reserve will pace interest rate increases; the sky may not fall immediately on all of commercial real estate, but shrewd investors and lenders should — and already are — questioning assumptions of where cap rates will be four to six years from now. This should render deals that boast sub-4 percent going-in cap rate deals, with projections of 6 percent NOI increases in perpetuity, particularly suspect. 1 Gateway metros are herein defined as: Atlanta, Boston, Chicago, Dallas, District of Columbia proper, Houston, Los Angeles, Miami, New York, San Diego, Seattle, San Francisco, and San Jose. Interest Rates, Cap Rates and Commercial Real Estate Values


CRE Finance World, Summer 2013
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