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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2006

Singing the Cap-Rate Blues

The market is seeing record capital, which could pose risks for investors

Real estate prices resemble valuations on dot-com companies in the late 1990s. While stock prices have only grown modestly in the past few years, after an abysmal performance between 2000 and ’02, commercial real estate values have since shown consistent double-digit growth.

We have seen increased demand for commercial property, limited supply caused by a construction moratorium (not at the discretion of developers), low interest rates and a solid gross-domestic-product-growth projection. Thus, real estate capitalization rates are approaching nanotechnological measurements.

Structuring challenges

Theoretically, a cap rate is the rate of return you could expect to receive in perpetuity if you pay “all cash” for an investment, with all other factors remaining constant. The formula for a cap rate is the net operating income (NOI) divided by the price of the property. It’s the “all cash” and “all other factors remaining constant” part of this equation to which we should pay careful attention.

According to the Federal Reserve, commercial/multifamily debt reached a record $2.5 trillion in the third quarter of 2005. Commercial-mortgage-backed-securities (CMBS) issuance also set a record at $169.2 billion in 2005. With the 10-year U.S. Treasury rate hovering around 4.5 percent, borrowers now are looking to lock in low interest rates.

Large senior loans have helped mezzanine lending become an instrumental part of commercial/multifamily finance. Today, a typical mezzanine loan falls in 80 percent to 90 percent of the capital stack, sometimes even greater. With a plethora of mezzanine capital available, returns to mezzanine lenders have been showing a steady decline, despite moving higher on the leverage curve.

As mezzanine lenders move into equity territory, they should be prepared to assume the role of a real estate operator, should the need arise. Mezzanine loans usually are secured by pledges of partnerships interests, which make it easier for a lender to step into the ownership position. When cap rates compress to a level that approaches the cost of debt capital, it is customary to consider more-innovative — and perhaps riskier — debt structures.

With properties trading at historically low cap rates, loans with interest-only and accrual features are accounting for a larger percentage of new loans. These features are not necessarily bad. If an operator is purchasing a property with a well-defined plan to increase value, both loan structures can help operators achieve their goal. Mortgage bankers certainly are earning their keep these days in devising innovate structures for their clients.

Seller’s market

Some securities-buyers are complaining that underwriting standards are becoming more aggressive. This does not seem to affect their willingness to purchase these securities, however.

If cap rates continue to fall — which is hard to fathom — lenders keep providing higher leverage, interest rates precipitously rise and market fundamentals deteriorate, we could be in store for a rash of loan defaults. It is interesting to note that at present, CMBS loan defaults are at an all-time low. With the economy rebounding, vacancy rates decreasing and rents increasing, buyers are motivated to continue an acquisition spree.

Those who have purchased or considered purchasing commercial real estate know that this is a seller’s market. We read about investors purchasing Class-A office buildings in New York for more than $1,000 per square foot and California neighborhood and community shopping centers selling at 5-percent cap rates. Multifamily properties in South Florida earmarked for condominium conversion are trading at 3-percent cap rates. To many buyers, current and projected market fundamentals can justify this optimism.

For example, consider the office-space sector. Nationwide, office sales in central business districts were $256 per square foot in the second quarter of 2005, a 25-percent jump in six months according to Real Capital Analytics, a New York-based research firm. The national office-vacancy rate, which fell from 16.6 percent at the start of 2004 to 15.4 percent at that year’s end, fell to 13.8 percent in the fourth quarter of 2005. New York and Washington, D.C., recently have recorded vacancy rates of less than 10 percent.

When vacancy rates decrease, rents usually increase. At a minimum, concessions are reduced or eliminated. Fully stabilized office properties in midtown Manhattan are trading at 5-percent cap rates. Sellers usually have potential buyers lined around the corner and require nonrefundable deposits for just the right to perform due diligence.

Although there is a positive near-term outlook for New York and other major office markets, the long-term outlook is less clear. Many large property-owners, including real estate investment trusts and pension funds, seek properties with substantial vacancies or properties with below-market rents. This may require investment in secondary markets that do not have the same liquidity as major markets. Cap rates for these properties are usually higher, but they require an experienced operator who can create value through effective management and leasing. This tact can be applied to every asset class across the board. It remains to be seen whether every buyer can demonstrate this business acumen.

Considering cycles

As for “all other factors remaining constant,” real estate cycles usually run from five to seven years. We had a great run from the mid-1990s to 2000. While most industry experts believe that commercial construction will be held in abeyance for the next few years, a new round of construction starts will inevitably begin once developers and lenders believe that the supply-demand balance favors new construction. When that happens, cap rates could rise for existing properties, as they will be competing with newly constructed properties for tenants.

Even without any new construction, interest rates alone can cause a precipitous cap-rate increase. Unlike long-term rates, short-term rates have been increasing steadily and are perceived as a financing vehicle for properties where value can be created in a short time. If long-term rates increase substantially, the cost of the debt alone would make acquisition economically unfeasible at today’s cap rates.

The housing market has been somewhat of an anomaly, showing sustained growth since the late ’90s. Some markets have seen home values increase 30 percent or more each year. Former Federal Reserve Chairman Alan Greenspan’s recent remarks about the housing market are reminiscent of the inimitable “irrational exuberance” comment about the stock market in 1996. If interest rates do spike, there will be a slowdown in the housing market. Multifamily-property owners would stand to gain if single-family homeownership becomes more expensive. External influences — from international conflicts to natural disasters — could have a profound effect on the U.S. economy.

•  •  •

It is clear that a record amount of capital has targeted commercial real estate as an investment vehicle. Experienced and novice investors are looking for and sometimes competing for the same properties.

Most experienced investors understand the risks and rewards associated with commercial real estate. Their well-being could be impacted, though, by Johnny–come-lately investors who may not fully understand the dynamics of a particular market. As a result, they may overpay for assets. Even large national real estate operators have “paid up” for a property they really need to have.

As no one is predicting any dire straits for commercial real estate in the foreseeable future, investors could be singing the cap-rate blues if everything does not remain constant. 


 


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