The capital markets environment over the past 18 months has been exceptional, given the abundance and low cost of capital. Capital has been reallocated from financial to hard assets, with commercial real estate receiving an increased percentage of investment resulting from foreign investors purchasing U.S. commercial real estate.
To set the stage, we looked at the U.S. commercial real estate capital stack at its peak in 2008, which registered $4.76 trillion and consisted of 52 percent private debt, 23 percent public debt, 17 percent private equity, and 7 percent public equity. According to NAREIT and the Federal Reserve, the commercial real estate capital stack as of the third quarter of 2013 consisted of $4.69 trillion, comprised of 35 percent private debt, 26 percent public debt, 26 percent private equity, and 13 percent public equity. In addition to more favorable market and economic conditions, historically low interest rates have played a huge role in the recovery of the commercial real estate market since the downturn.
Commercial real estate generally is valued by applying capitalization rates (cap rates) to a property’s year-one operating income. Historically, cap rates and interest rates have been proven to be highly correlated. Thus it is fair to assume that if all other variables remain the same, an increase in interest rates will increase cap rates and thereby decrease property value. Property pricing has been increasing recently, despite upward movement in interest rates, representing compression in the spread over the 10-year Treasury rate.
Fundamentally, the recent increase in interest rates is a result of stronger economic growth. In theory, stronger economic growth will lead to increased demand for space and higher rents, offsetting the rise in interest rates. On the development side, rising interest rates also increase the cost of construction as well as financing, generally resulting in less new product. With less available space saturating the market and steady demand from tenants, rents can increase, bolstering overall operating income, assuming operating expenses remain stable. These economic and market fundamentals are poised to offset any decreases in property value due to interest rate hikes.
The current state of the nation and economic growth will continue to play an important role in commercial real estate. The decision by the Federal Reserve to taper its quantitative easing program in response to steady improvements in the economy will lead to an uptick in borrowing rates. Most transactions that made sense before the increase in interest rates still will make sense afterwards, as investors have been compressing their internal rate of return (IRR) and cash-on-cash yields for core Class A product. Many investors believe that greater demand and, therefore, higher rent increases for secondary Class B product will more than offset increases in borrowing costs. Because premium pricing for core assets and Class A product is coinciding with rising interest rates, capital is beginning to chase higher-yielding assets in secondary submarkets.
Historical Property Sales Volumes
In 2008 and 2009, the global capital markets encountered challenging times, as the U.S. economy and declining fundamentals such as gross domestic product (GDP) and job growth created significant confusion for investors. Real Capital Analytics indicates that U.S. real estate investment sales (including office, retail, industrial and multifamily assets) in 2009 totaled $66 billion, down 88 percent from a peak of $570 billion in 2007. Since 2009, year-over-year U.S. real estate investment sales increased 120 percent in 2010, 59 percent in 2011, 30 percent in 2012 and 19 percent in 2013 because of cap rate compression and generally improving economic fundamentals.
Product Type Pricing
In 2013, capitalization rates moved back to the low levels recorded in 2005 through 2007 of about 4 percent for core assets in major markets. Supply-constrained markets and 24-hour cities have been the targets for investment in almost all product types. Major markets — Manhattan, Los Angeles, Chicago, Boston, Dallas, Houston, and Atlanta — all had more than $10 billion in sales volume in 2013. With increasing interest rates on the horizon, however, investors are gradually moving up the risk curve, as suburban and second-tier markets gain momentum from investors looking for higher yields. In 2013, higher-yielding markets such as Orlando, Fla., Las Vegas, Hawaii and Philadelphia saw year-over-year increases in sales volumes from 2012 of more than 70 percent, while the U.S. as a whole has seen a 19 percent year-over-year increase, according to Real Capital Analytics.
Industrial. U.S. sales of industrial properties increased 16 percent year-over-year in 2013, according to Real Capital Analytics. Historically, total industrial sales have increased from the 2009 low of $10.7 billion to $20.2 billion in 2010, $35.4 billion in 2011, $40.6 billion in 2012 and $47.0 billion in 2013. Major institutional groups have begun showing significant interest in industrial product, leading to record per-square-foot pricing and cap rates ranging from 5 to 6 percent in major markets. HFF recently closed an industrial portfolio in Northern New Jersey at a 5 percent in-place cap rate and is in the process of closing a second Northern New Jersey portfolio with similar pricing. As more institutional groups become interested in industrial product and the improving economy increases the need for industrial space, property prices are expected to continue to set record highs.
Office. Total office sales have been steadily increasing from 2009 lows of $17.4 billion to $46.0 billion in 2010, $65.5 billion in 2011, $81.1 billion in 2012 and $101.5 billion in 2013. The office market is still in the midst of an ongoing recovery, with core investments targeting in-place cap rates between 6.25 and 7.5 percent, core-plus investments targeting in-place cap rates between 7.5 and 9.5 percent and opportunistic investments aiming at returns of 9.5 to 11 percent plus. HFF recently closed a suburban New York office portfolio that achieved significant interest and closed at a mid-7 percent cap rate, and the firm is marketing a single-tenant office building that is anticipated to trade at $100 million or a low 6 percent cap rate. Sales volume in central business district (CBD) office markets has returned to 2007 levels, while suburban office sales volume is slowly following. But we are still a long way from the 2007 peak in office transactions that reached $211.9 billion.
Retail. Retail property sales in 2013 were up 8 percent from 2012 to $60.8 billion, due to a number of institutional investors and equity funds accumulating retail strip centers and single-tenant properties. Increased activity in the retail sector from institutional and private buyers is causing prices to rise further.
Grocery-anchored centers and big box retail outlets have been highly sought after. Core 24/7 locations in the Northeast are achieving in-place cap rates of 5 percent. In 2013, HFF was involved in the sale of a grocery-anchored strip center in Northern New Jersey that closed at a 6.3 percent cap rate. This is comparable to the sub-6.25 percent cap rate being discussed at a similar grocery-anchored property in Northern New Jersey, indicating that the increase in interest rates has not affected grocery-anchored retail product. Cap rates for grocery-anchored properties are expected to stay at historic lows because of the scarcity of the product.