Commercial Real Estate Values Rising Due to Cap Rate Compression

My previous posts have discussed this situation in Hong Kong and Singapore, but the same phenomenon is at work in the U.S., too. http://www.internationalappraiser.com/2010/12/asian-growth-story.html
http://www.internationalappraiser.com/2012/12/hong-kong-revisited-risks-presented-by.html

Many are trumpeting the return of rising commercial real estate values in the U.S., but how much of this rise is organically grown rather than the effect of artificially low interest rates?  By “organically grown” I mean growth based on improving net operating incomes at the properties being measured.
Buying properties just because the market is going up due to cap rate compression would be just as illogical as buying stocks because their price/earnings ratios are going up.  Such an investor would just be paying more for the same amount of income.

Last fall I appraised a portfolio of southern California industrial and retail properties for a divorce, requiring me to estimate market values as of year 2013 and year 2002.  All but one property had increased in value in those 11 years and the average increase was 51%, yet the majority of properties were earning less net operating income (NOI) than 11 years previously.

Examining just those properties that suffered declining net income, the average NOI was 17% below 11 years ago, but the average value was 28% higher than 11 years ago.

What made these declining properties worth more?  The most obvious answer is the compression of capitalization rates in response to artificially low interest rates resulting from the Federal Reserve Bank’s doses of “quantitative easing”.  The range of cap rates in 2002 was 7.5 to 9%.  The range of cap rates in 2013 was 5.5 to 6.1%.  NOI divided by .055 is going to yield a much higher value than NOI divided by .09.

One could argue that today’s low cap rates are a vote of confidence in the future of these properties and a rebounding economy, but how can one be confident about properties that have been declining in economic performance for the past 11 years?    

It requires a leap of faith to value these properties as if their NOIs will start rising again, particularly since these were mostly older properties, built before 1980.  Yet, I’ve seen this happen once before, in the early 1980s, when the lack of commercial real estate construction after 1974 resulted in a serious shortage of commercial space by the end of the 1970s.  Nevertheless, I don’t see a nationwide shortage of commercial space today, only some small pockets which have supply constraints.

The concern I have here is that when the Fed tapers its “quantitative easing”, the consequent rise in interest rates will quickly reverse the gains in commercial real estate value.  In a matter of months we have already seen the US 10-year bond rate rise from 1.6% to 2.82%.  Is this a portent of rising interest rates to come?

For instance, what if cap rates returned to the levels of 2002?  The subset of properties that fell 17% in NOI but rose 28% in value would consequently see a 35% reduction in value from today’s values. 

“Quantitative easing”, of course, is just a euphemism for “money printing”.  My economics courses at the University of Chicago taught that the consequence of rampant money printing was inflation, which is indeed what happened in the 1970s in the U.S.  Inflation can manifest itself in consumer prices, or also, more recently, in asset price inflation, as the extra money now somehow finds its way into the coffers of the upper class, enabling them to bid up equities and art prices to record levels.  It’s getting so hard to buy a decent Picasso for less than $20 million nowadays.

The natural consequence of inflation is an increase in interest rates, as investors want to be compensated for the erosion of purchasing power over time.  Real estate capitalization rates are correlated with interest rates, so one can expect the commercial real estate market to face some major headwinds in the future.

Similar consequences may happen overseas, too, as all of the major central banks, even China, which did it again today, have been printing money to recover from the Global Financial Crisis 5 years ago.

Soundly run nations, such as Switzerland, are also adversely affected by the declining level of confidence in other currencies.  When investors lost confidence in the Euro, for instance, they traded Euros for Swiss Francs, temporarily elevating the value of the Swiss Franc before the Swiss government stepped in to devalue its own currency in order to preserve its export markets.

In my previous travels in Asia, I’ve seen commercial properties sold at ultra-low capitalization rates, in the 2 to 3% range, in places such as Hong Kong, Singapore, and Shanghai.  Residential cap rates are even lower.  With cap rates this low, there is little margin for interest rate increases before the streets become flooded with red ink and real estate values are pushed downwards.

Singapore skyline.  Top photo: Hong Kong Central

 

Hong Kong Revisited -- Risks Presented by Low Cap Rates

View of Hong Kong Central from Kowloon, November 2012

Returning to Hong Kong 18 months after my previous post, I found residential prices had increased 23% this year alone as of October, and 87% since 2007, causing the Hong Kong Monetary Authority (Hong Kong's central bank) to worry that “the disconnect between property prices and economic fundamentals” presents “macro-financial risks” to the Hong Kong economy.

Globalpropertyguide.com has reported rental property capitalization rates in Hong Kong have declined to a range between 2.2 and 3.6%, and as low as 2.13% in The Peak neighborhood, and The Economist has reported an estimate that Hong Kong homes are 69% overvalued when compared to the rental income that they can produce.

Ultra-low real estate capitalization rates in Asia, such as in Hong Kong, present a bubble that lasts only until interest rates return to normal levels. Hong Kong already has a history of these bursting bubbles, such as the office market in 2004, declining 30% the following year, or the residential market in the Asian Contagion of 1997, when average prices declined 63% from peak to trough.

The Hong Kong government has already taken measures to discourage speculation, such as lowering loan-to-value ratios on mortgages and imposing stamp duty taxes of 15% on home flippers and foreign buyers, but such measures also send signals that housing prices are still headed upwards.

A Barclay’s report this year shed some light, though, on the gain in housing prices, reporting that the proportion of investor-buyers increasing to 70% and that 60% of homeowners have no mortgage. This points the reason for the price gain in the direction of foreign buyers, particularly the Chinese mainland, who often do not occupy their Hong Kong homes but treat them as “safe haven” assets.

With home affordability in Hong Kong at historic lows, any events that call in to question Hong Kong’s “safe haven” status, such as an interest rate shock, could cause it to suffer the fate of most of the second home markets the world over, although there is always a need for a safe haven somewhere. London, New York and Dubai have been recent popular destinations for foreign buyers with this aim in mind.

Hong Kong benchmark interest rate history -- HK Monetary Authority

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Hong Kong: Lofty Housing Prices, Low Capitalization Rates

As a global financial center, Hong Kong ranks third and is rapidly catching up with New York and London, bringing in expatriate financial workers to fuel the Asian financial expansion, as Hong Kong is clearly the financial hub of the Asia-Pacific region. Its shortage of land also has created some of the world’s highest real estate prices.

In a recent government auction of land, for instance, three sites sold for a combined price of about $700 million. Sung Hung Kai properties, for instance paid $4.49 billion Hong Kong Dollars, or about $577 million USD, for the sloping 3.63-acre former Lingnan University site, equivalent to $1160 USD psf of land or about $3650 USD per buildable square foot, as the maximum allowed buildable area is only about 180,000 square feet. Completed homes, having views due to the slope of the site, are forecasted to sell for over $5000 USD psf.

China Overseas Lands bought a 30,237sf site in Kowloon for HK$578 million, or about $74 million USD, equivalent to $2458 psf of land. They expect to build only ten houses, which will sell at a price of over $3000 USD psf. The price per buildable square foot is $1850 USD.

While these land prices might not seem high by Manhattan standards, when one considers the low density zoning, the price per buildable square foot is much higher than Manhattan.

Real estate prices have been rapidly climbing in sympathy with near-record sales prices, and a high-floor condo near Lingnan University recently raised its asking price to over $3000 USD psf, with other sellers reported to be increasing their asking prices from 10 to 30%.

The highest recent home sale, at 20 Peak Road, was HK$750 million, or almost $100 million USD, equivalent to the highest residential sale ever achieved in the U.S. The average luxury home price psf was estimated by CBRE at HK$21,351, or about $2700 USD per square foot, 14.5% higher than one year ago, and the overall residential property index jumped 24% from one year ago.

Meanwhile, just as in Beijing and Singapore, the Hong Kong government is taking extra measurements to prevent a housing price bubble fueled by speculators, instituting a 5 to 15% tax duty on residential resales within two years of purchase, and lowering LTV (loan-to-value ratios) to 50% on all non-owner-occupied residential properties, in addition to the aforementioned auction of government land (although the balance between supply and demand could have been improved with some up-zoning).

The vacancy rate for the luxury rental market was last measured by CB Richard Ellis at 1.9% and falling as highly paid financial industry workers are imported into Hong Kong.

The highest reported recent house rental was about $25,000 USD per month for a house at The Peak, and the highest flat rentals have been at about $20,000 USD per month. CBRE estimated the average rent psf for luxury flats at HK$37.70 psf, or about $4.75 USD psf. Serviced apartments, a typical housing option for a visiting expatriate, are leasing in the range of HK$44 to $57 psf per month, 13% higher than one year ago..

As for multifamily investment, unleveraged yield rates are now below 3%, fed thus far by ultra-low mortgage interest rates by local banks, lower than 1% until recently, but some lenders are now starting to raise rates, with Hong Kong Financial Secretary John Tsang warning consumers and investors not to count on cheap credit forever. Meanwhile, mortgage interest rates are also increasing in mainland China.

Is the Hong Kong housing market a bubble waiting to burst? Housing prices were actually slightly higher in 1997, before the Asian financial crisis of 1998, which was started by a real estate bubble in Thailand. This time, the Hong Kong government is doing its best to implement measures to achieve a “soft landing”, legislating conservative LTV ratios and short-term gains taxes unheard of in the United States.

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