Investors Ignore Higher Interest Rates

Higher interest rates are not influencing cap rates for most types of property and are not slowing down investment volume as buyers continue to bid heavily on properties …

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Higher interest rates are not influencing cap rates for most types of property and are not slowing down investment volume as buyers continue to bid heavily on properties in core markets. Experts say that a 1% interest rate hike was anticipated due to the Federal Reserve’s earlier announcement that it may pull back on economic stimulus, and so did not impact transactions; however, if rates edge any higher it may start to have an effect. Analysts note that buys continue to be big in premium markets despite higher prices, particularly in places like San Francisco and New York City. For more on this continue reading the following article from National Real Estate Investor.

The numbers are coming in—investors are largely ignoring the big jump in interest rates that took place earlier this year. They continue to buy properties in roughly the same places they focused on before interest rates rose at about the same prices relative to the income from the properties.

The latest data from CoStar show that investment sales volume has held up in the months since rates have risen.

“Investors were expecting that interest rate rise,” says Walter Page, director of U.S. research for office for CoStar Inc. “A 1 percent rise to interest rates was fully baked into the numbers.”

However, a further rise in interest rates could have a noticeable effect, says Page. Specifically, another percentage point added to the yield on 10-year Treasuries and other investments that compete for investor attention with commercial real estate could add half a percentage point to cap rates.

For now, prices have continued to rise for top properties in core markets.

“We’ve seen some record pricing on stuff across the country,” says Page. For example, the CoStar’s numbers show that for the top 20 percent of sales for office buildings in New York City the median price continues to climb past $1,200 per square foot. That’s 12 percent greater than the previous peak of 2007 for the New York City office market. “There’s a similar story in San Francisco,” Page says.

Investors continue to bid prices higher for prime properties in the most expensive, core markets. The volume of investment sales is also relatively unchanged, according to preliminary numbers from CoStar. A total of $20.4 billion in office properties changed hands in the second quarter in the U.S., up slightly from both $18.4 billion in the first quarter and from $19.3 billion in the second quarter of 2012. The high volume of transactions has continued in the third quarter, Page says.

Prices continue to be strong for most property types—with the possible exception of garden apartments, whose prices have slipped slightly relative to income. “The only real place we are seeing cap rates tick higher is with garden apartments—up about 20 to 30 basis points nationwide,” says Dan Fasulo, managing director for Real Capital Analytics (RCA). Average cap rates for garden apartments are now around 6.5 percent—up from 6.2 percent at the beginning of the year, with the bulk of that uptick taking place in the Spring.

Cap rates for other property types continue to be low, according to RCA, with apartment overall at 6.1 percent. Average cap rates for office properties have fallen to about 6.8 percent from 7.1 percent earlier this year. Average cap rates for retail spaces are at 7.0 percent, down from 7.1 percent.

Interest rates rose sharply earlier this summer after officials at the U.S. Federal Reserve said they might begin “tapering” off their quantitative easing program later this year. The markets immediately responded. The yield on 10-year Treasuries rose steadily from below 1.8 percent in May to over 2.9 percent today.

Investors had been expecting interest rates to rise, according to Page. He could see that earlier this year in the difference between the capitalization rates on sales of commercial real estate properties and the yield on 10-year Treasury bonds.  “The spreads were abnormally large,” says Page. The increase in Treasury bond yields has put the difference between cap rates and Treasury bond yields into a more normal range.

Also, an extra percentage point in yields for Treasury bonds has not turned into a full extra percentage point in interest charged to commercial and multifamily real estate properties. In part that’s because most lenders never offered interest rates as low as one might expect, given the low yield on Treasuries. Instead the spread charged by lenders widened as lenders kept the extra for themselves. “Banks didn’t follow the Treasury rates all the way down,” says Fasulo.

So when Treasury yields rose again, banks didn’t have to add that rise directly to their interest rates. Once again, another increase in Treasury yields would probably have a much more clear effect in the interest rates charged to commercial and multifamily properties… and to real estate prices.

This article was republished with permission from National Real Estate Investor.

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