By now, we have all heard the story: Federal Reserve Chairman Ben Bernanke, in his mid-June remarks to the House Financial Services Committee, suggested that the central bank may begin scaling back its monthly $85 billion in bond purchases, also known as Quantitative Easing, by the end of 2013. Although the hypothetical timeline of tapering was several months out and entirely predicated on a stream of positive economic data, the market’s reaction has been a spike in bond yields – namely a 70- to 80-bps increase in the 10-year Treasury. The recent movement in interest rates has left many property owners and investors wondering how cap rates (i.e. property values) will be affected.
While the recent rise in interest rates certainly is not welcome news to borrowers with floating-rate debt or would-be borrowers currently looking to secure mortgage debt, from a historical perspective the market is still in a low-interest rate environment. Whether it is a new development, an acquisition or a refinance, most leveraged transactions that made sense 60 days ago still make sense today. However, for the “core plus” and investment-grade assets that have been trading at sub-5% and even sub-4% cap rates (Net Operating Income / Purchase Price), many proposed transactions may no longer make sense.
Let’s take for example a Class ‘A’ multifamily project marketed at a 5.0% cap rate. Even at a low interest rate of 4.0% on a 30-year amortization schedule, the loan constant is 5.7% – meaning that you are paying more for your debt than your asset is paying you. The result is that your cash-on-cash return (Cash Flow After Debt Service/Invested Equity) is lower than the unlevered project returns (i.e. negative leverage).
In this scenario where it makes less sense to leverage the investment, the pool of potential buyers has shrunk to those who can fund the acquisition with all cash and those who are extremely bullish on the investment and thus are willing to accept negative leverage in the short-term, banking on rent growth in the intermediate / long term. The fundamental rules you probably learned in your first economics class apply: smaller pool of buyers = less demand = lower prices. In real estate circles, we often describe lower prices in terms of higher cap rates. In other words, the market is willing to spend less for the same net operating income. Now that interest rates have crept up, a reasonable assumption would be that cap rates will surely follow as would-be sellers are forced to either recalibrate their pricing expectations or to pull their properties off the market – depending on their investment/hold strategy.
However, as mentioned above, Bernanke has stated that the Fed will not begin tapering asset purchases until it is evident that broader economic growth is strong enough to sustain the tapering. Presumably, economic growth would include growth of personal wages, industrial production, retail spending, etc., all factors that translate into positive property market fundamentals, which theoretically put downward pressure on cap rates.
If the scenario of the Fed tapering its Quantitative Easing program as a response to strong economic growth were to come to fruition, the interesting net result may be investor interest shifting down the risk/return curve from safe “core plus” assets to riskier investments with potential to produce greater returns. Whereas investors had previously been flocking to safer core assets and being content with modest returns, as the broader economy continues to strengthen, we may see more investor interest in “value-add” assets. The result would be a shift from the property market being primarily driven by risk aversion to true entrepreneurial real estate investment and development – driven by strong market fundamentals. This is the ideal environment for entrepreneurial real estate investors to create value.
At Metropolitan Capital Advisors, a commercial real estate capital intermediary, we have assisted our clients in raising over $9 billion in debt and equity capital for virtually every type of investment strategy from value-added development to investment-grade passive investments. Please contact any of our Senior Directors to assist you with your financing needs.