Historically low interest rates and an abundance of investment capital drove commercial real estate prices to record levels in 2004 and have kept activity strong year-to-date. More than $170 billion in U.S. commercial transactions were completed last year, an increase from $120 billion in 2003, according to Cushman & Wakefield.
The most striking characteristic of this phenomenon is the aggressive pricing real estate has commanded in an environment of weak leasing fundamentals. The question nearly all investors are asking is whether the last seven consecutive increases in the fed funds rate, from 1% to 2.75%, will put downward pressure on property values, and when that might occur.
Most experts expect the Federal Reserve to increase interest rates gradually but consistently over the next six or seven quarters. If the Fed follows that plan, the rate increases will drive up cap rates. And when cap rates rise, all else being equal, property values will fall.
That said, property values should be sustainable through the end of 2005, with interest rates having the potential to increase cap rates in 2006. Increases in cap rates, which are inevitable as interest rates rise, will lag the increase in long-term interest rates.
Unique set of circumstances
There are other factors emerging in the market that should keep values afloat, despite rising interest rates. The first is that there continues to be more demand and capital for real estate than there is real estate available to invest in. The second is that demand is coming from multiple competing sources of capital, which will more than offset the crimp rising interest rates will put on valuation analyses.
Historically, a single category of buyer has driven the real estate investment markets in different cycles. So, in the mid-1980s, tax-driven syndications pushed valuations upward. In the late-1980s, a flood of capital from Japan dictated pricing. The 1990s saw, in succession, opportunity funds, REITs and offshore investors (especially German open-end and closed-end funds) dictating valuations.
The distinguishing characteristic in today's market is that capital is flowing from numerous competitive sources including REITs, pension funds, offshore entities, institutional investors and TICs. To illustrate the point, two major office buildings under contract to be sold in New York City in the second quarter of 2005, 200 Park Ave. and One Madison Ave., generated interest from private investors, institutional investors and REITs. The winning bidder on One Madison Ave. was a REIT, and the winning bidder on 200 Park Ave. was a private investor with access to institutional capital.
This wide range of competitors, coupled with the gradual improvement of underlying leasing fundamentals, will sustain property valuations through the end of 2005, despite interest rate increases. Since the supply of capital crosses investor sectors, the market will not collapse if increasing interest rates dampen the appetite of leveraged investors. And interestingly, other than a few trophy sales in New York City and Washington, D.C., very few markets are trading at or above replacement cost.
Vital signs grow stronger
Helping to sustain this demand will be improving real estate fundamentals, increased net operating income and limited new construction completions. The national office market has begun to see overall declining vacancies and increasing rents, and the national employment picture continues to improve, with more than 200,000 jobs added in February alone.
Real estate outperformed the bond markets (as measured by the Lehman Aggregate Index) and the stock markets (as measured by the S&P 500) over the last one-, three- and five-year periods. The unattractiveness of these alternative investments helped foster aggressive demand for real estate and sustain pricing.
Owners have responded by putting a record amount of real estate up for sale. At Cushman & Wakefield, the dollar value of closings is running 40% ahead of the same period last year, and the brokerage company has $11.3 billion of listings on the market. Historically, that figure would be closer to $8.5 or $9 billion.
The Fed's decision to raise interest rates seven times over the last 12 months has not dampened investor interest or pricing levels. Improving fundamentals — including declining vacancies, increased rents and a brightening employment picture — have kept investors hooked on real estate.
As commercial real estate evolves further into an accepted asset class, and as capital continues to flow into real estate, property values are likely to shrug off interest-rate hikes in the near term.
Timothy Welch is an executive managing director and head of investment sales for Cushman & Wakefield.