Monday, January 20, 2014

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.

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



George R. Mann, CRE, FRICS, MAI said...


This is exactly why I contend there is a difference between Price and Value. The intrinsic value of the properties you appraised have remained level to more likely declining as their NOI shows. Their value is level to down. Their Price is up. Two totally different things.

However, the problem in the USA is our definition of Market Value references 'price.' I say it is like trying to define an orange 'as an apple....blah blah blah.' It makes no sense to define value with price or cost in the definition. Until we change this grave error, we'll just continue our huge corrections that wife out trillions of dollars of 'value.'

Vernon Martin, MSRE, CFE said...

You're preaching to the choir, George. When I contemplate the difference between price and value, I think of the writings of Warren Buffett, who has made a lot of money knowing the difference between price and value. Nevertheless, the appraisal profession boxes me in to what I can do.

Anonymous said...

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