What's driving cap rate compression?

After a recent client event in New York, I spent some time discussing the markets with KC Conway, chief economist in the U.S. for Colliers. It turns out we’re hearing the same question come up pretty frequently: What’s going on with cap rate compression? (KC has been having similar conversations regarding cap rates with bank regulators.)

Over the past 24 months, U.S. capitalization rates for all income-producing property types have declined to levels never seen before. Rate compression has been most pronounced in multifamily and credit-tenant, net-leased properties, where rates have dipped below 4.0%. Cap rate compression has been slower to occur in industrial real estate; however, that’s changing rapidly as investors rotate out of multifamily, and look to invest in the re-making of America’s supply-chain in response to growth in e-commerce and the Panama Canal expansion.

The Historical Perspective

As this graphic shows, we’re clearly in uncharted waters. The long-term average cap rate between 1965 and 2010 was 9.5%. After dropping to nearly 6.0% prior to the onset of the 2007-2009 financial crisis, cap rates rose sharply between 2008 and 2010 to 8.5%. This increase, around 200 basis points, eliminated approximately 25 percent of commercial real estate values. During the recession, increasing vacancy rates and declining rents caused another 20 percent decline in values, as indicated by the Moody’s Commercial Property Price Index (CPPI).

Source: American Council of Life Insurers.

All told, roughly 45 percent of the value of commercial real estate was wiped out from 2008 to 2010. But less than three years after the “Great Recession,” commercial real estate values have rebounded. Institutional capital and commercial real estate investors are pursuing income-producing real estate again, and have bid average cap rates to a new historic low: under 6%. Why; and what is behind this trend?

Many ascribe the trend to institutional investors’ ongoing search for yield, but of equal import is investor anxiety over Federal Reserve monetary policy aimed at devaluing the U.S. dollar and re-inflating asset prices out of the risk curve. With a 10-Year Treasury yield around 1.8% and inflation near 2%, commercial real estate certainly seems more attractive--even at a historically low 4% to 5% cap rate.

What about equities or stocks? Here commercial real estate is increasingly attractive because of its relative stability. With most major U.S. stock indices at near-record highs, and the volatility in electronic trading that can move equity prices by as much as 5% in a single day, commercial real estate is a consistent way to attain cash-on-cash yield above 4% (and as high as 7% or 7.5% in secondary markets) without the daily fluctuation in asset price.

But there could be more to this trend than just a search for yield. The approaching retirement of millions of baby-boomers may see investor goals shift toward cash flow and dividends, and away from long-term asset appreciation. Certainly low interest rates have also been a factor. Would multifamily cap rates be in the 4-5% range without cheap Freddie Mac and Fannie Mae debt? 

The question is whether cap rates must necessarily spike as interest rates rise. With so much capital on the sidelines waiting to be invested, could the conventional wisdom of overleveraging--because equity is expensive and debt is cheap--be turned upside down in the next five years? 

Investing from the Ashes

Yesterday I had the opportunity to appear on a very interesting panel at the Bloomberg Commercial Real Estate Conference: “Investing from the Ashes: The Distressed Market.”

The panel examined the investment outlook and areas of both risk and opportunity in distressed real estate. Representing the viewpoint of special servicers was Robert Lieber of C-III Capital, while Billy Macklowe offered the owner’s perspective, focused particularly in New York City.

As was mentioned on the panel, right now the outlook for distress is a mixed bag: We’re at a four-year low for new distress, but there are signs that 2013 volume will increase. CMBS loans remain the largest share of outstanding distress, and there’s another major wave of delinquency in the future as the 10-year loans from 2005-7 mature.

We see the next generation of opportunity is in secondary markets, where population growth and fundamentals (housing, job growth, etc.) are starting to rebound. In some cases like Tampa and Memphis, these markets are early beneficiaries of the shift in global trade patterns and changes in our logistics network in anticipation of the 2015 Panama Canal expansion. We also see industrial property as a stable asset class, with the least exposure from CMBS distress.

From our perspective, the greatest market risk is from interest rate sensitivity. A rise of 200 basis points in interest rates over the next two years—below the long-term trend—could, by our estimation, potentially add 20 to 25 percent new distress to the market. The hope, of course, is that interest rates would be rising in response to other positives in the economy as a whole, but it’s nonetheless a major risk for investors in the distressed space.

I very much enjoyed the opportunity to participate, and hear the perspectives of our peers in the market. Thanks to Beth Jinks and Bloomberg News for making it possible.

Here is a link to the video: http://bloom.bg/PShonm