This article was posted on Tuesday, Oct 01, 2013

Even as the economy appears to be gaining traction thanks to the flood of low-cost stimulus money that has flowed through markets, commercial real estate executives and economists vacillate between wonder and dread.
In DLA Piper’s annual temperature-taking of the Commercial Real Estate (CRE) industry, 85% of senior executives at commercial real estate firms surveyed reported having a bullish outlook for the year ahead, reversing a far more pessimistic view two years ago at the dawn of the economic recovery. Driving that optimism for 56% of the executives is a combination of current low interest rates and abundant debt and equity capital.
At the same time, just 40% named the improvingU.S. economy as a reason for their bullishness.

Analysts and executives throughout the industry, including economists at CoStar Group, have spent considerable time in recent weeks thinking about what will happen when the Federal Reserve finally eases back on quantitative easing and, as CoStar Managing Director Hans Nordby put it, “interest rates start to get normal again.”
This week, the Federal Reserve reiterated its plans to keep short-term rates at record lows until the U.S. unemployment rate falls to 6.5%, and continue buying $85 billion a month in Treasurys and mortgage bonds to keep long-term loan rates down. At the current rate, the Fed doesn’t foresee the jobless rate falling to 6.5% until at least the end of 2015.
Asked to identify the single-largest issue or challenge facing the CRE industry, many DLA Piper respondents cited such factors as the “potential for rapidly rising interest rates,” “a mid-term squeeze on liquidity when interest rates go up and existing debts come due,” and “readily available low-cost debt, resulting in loosening underwriting standards,” as the biggest risks to the market they see.
While it’s certainly a golden age for capital availability, it’s not so golden for real estate fundamentals, said Sam Zell, chairman of Equity Group Investments, during the keynote discussion at DLA Piper’s 11th Annual Global Real Estate Summit this week in Chicago.

“In terms of the cost of leverage, this is the cheapest cost of capital since the ’50s. But it’s not a golden age from a demand perspective,” the legendary real estate mogul and billionaire dealmaker told his audience.

Largely due to the recovery in credit markets, CRE capitalization rates are close to their historic lows for most property classes, even as other property level fundamentals remain relatively weak.
In a new report, John Kainer, a senior economist in the Economic Research Department of the Federal Reserve Bank of San Francisco, notes that the apparent disconnect between low cap rates and still-weak fundamentals has prompted concern among some analysts that the Fed’s low-interest-rate policy may excessively boost property prices.

At this point, however, concerns about excessive pricing “don’t appear to be warranted,” Krainer said in his report.

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Meanwhile, more than two-thirds of executives in the DLA Piper survey believe that cap rates will hold steady, with nearly 20% predicting that cap rates will fall even further – a sign they believe CRE prices will continue to rise.

“It’s true that cap rates are at historic low levels… [However] many market interest rates are at or near historic lows, so low cap rates are not anomalies,” according to Kainer, adding that it’s important to compare cap rates with other financial market yields rather than with cap rates during earlier market periods.

Cap rates could continue to fall, but CRE on a relative basis is fairly valued compared with fixed-income assets, noted John Affleck, international economist for Property and Portfolio Research (PPR), a CoStar company.

“Among major asset classes, only commercial real estate offers a yield on par with 2007 levels,” Affleck said. “While cap rate levels may have investors reliving bad memories from 2007, spreads over risk-free rates are as wide as ever for CRE, dangling the prospect of further cap rate compression while fundamentals continue to recover.”

Industry titans such as Zell and Steven Roth, chairman of Vornado Realty Trust (NYSE: VNO), have offered an alternative point of view recently.

In his widely read annual letter to shareholders, Roth said he expects interest rates to stay lower for longer than pundits expect, and “we are near the tipping point where market participants will start to believe and act as if it’s their God-given right to zero-bound interest rates,” noting that highly leveraged players backed by new credit market participants are back in the market, as are 85%-90% loans on a menu of mezzanine, pay-in-kind and participation loan products.

“We are in an extended period of easy money, worldwide – central bankers as Santa Claus. I have no idea, and doubt that anyone does, how to unwind this easy money feast,” Roth said. “I can see the bubble on the horizon; the fat lady entering the building.”

As such, Roth said he doesn’t expect cap rates to rise anytime soon, and Vornado will likely be a net seller of properties this year, he said.

“Our basic instinct is to build, acquire and grow. But, my belly tells me that prices are now higher than future prospects and therefore, we will buy carefully and likely sell more than we buy,” according to Roth.

The large amount of soon-to-mature debt underwritten at very low interest rates is “the one inherent issue” in the real estate world, said Zell during his discussion with Jerry I. Speyer, chairman and co-CEO of Tishman Speyer during the DLA Piper Global Real Estate Summit. Meanwhile, demand is skewed heavily toward the “24/7 cities” that continue to grow and attract a disproportionate percentage of the young aspirant population, he said.

“It’s not like interest rates need to be 10%. They only need to be 4% in order to create significant havoc going forward. I don’t think we can maintain these kinds of docile interest rates forever. It’s very hard not to see interest rates going up in the future, and for that to be a destabilizing factor.”

Asked about the long-term implications of what DLA Piper moderator Dale Anne Reiss called “artificially low interest rates,” Zell noted that wild inflation ensued 3 ½ years after former President Richard Nixon imposed price controls on the economy in 1972.

“Do I think we’re going to have inflation here? More and more, I don’t understand how we can’t.”

Zell said the speed at which interest rates rise could determine the level of instability they cause in the economy, with very slow increases over a long period of time the optimal choice.

“History shows we’re not so good at that,” he said. “The body of thought is that [a crisis] happens, and it changes perceptions, and all of a sudden, the price of capital changes. The way the whole world is dependent on the low cost of capital that would be a significant disaster.”

Overwhelmingly, DLA survey respondents buy the Fed’s assertion that interest rates will rise only slightly or stay the same for the upcoming year.
While a sudden spike in interest rates would reverberate across the market, “there is little concern that interest rates will rise in the near term,” counseled Jay Epstien, chair of DLA Piper’s US Real Estate practice and co-chair of its global real estate practice.

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