Investment Real Estate Interest Rates – The Foggy Future

January 12th, 2012Apartment Real Estate • Interest Rates7 Comments

We are just over a week into 2012, and all of the 2012 economic and investment real estate forecasts are surfacing. Reputable sources like Kevin Maggiacomo (CEO, Sperry Van Ness), Marcus & Millichap Research, Grubb & Ellis Research, and the Linneman Letter (Dr. Peter Linneman) are all communicating a sentiment of conservative optimism for the coming year. There seems to be agreement across the board on several issues:

Investment real estate has been a safe haven investment during 2011.
Commercial real estate assets have recovered a good portion of their value since 2008.
Artificially low interest rates have helped keep investment real estate opportunities attractive DESPITE contracting CAP rates.
Slightly positive job growth at the close of 2011 combined with optimistic job growth forecasts for 2012 should keep investment real estate’s momentum.
There is a tremendous amount of political and economic uncertainty.

You’ll notice that despite the admission of political and economic uncertainty, investment real estate has done well and is expected to continue to do so. So things do look positive for the near term, but how about the medium term (3-5 years)? Here I would like to add a few thoughts, and while I know I am NOWHERE near as qualified as the esteemed sources I have quoted above, I hope you will just hear my short thoughts out.

The Medium Term

I’ve titled this post “Investment Real Estate Interest Rates – The Foggy Future” because I believe that interest rates will be the deciding factor in how the next 3-5 years will play out with regard to commercial real estate investments. Let’s highlight the problem:

Interest rates are at a near all-time low, making commercial real estate assets more affordable. (Doesn’t sound like a problem to me… Please continue.)
These interest rates are artificially low, held there by government and FED policy.
With fears of inflation continuing to pop up, the government cannot hold rates at these artificial levels indefinitely.
Rental markets have strengthened in the last 2 years, leading to lower vacancy and higher property values. One direct result of this is CAP RATE CONTRACTION.

And there is the issue I would like to address. Yes, strengthening rental markets and property value appreciation are both great things. They are good for owners and bode well for the economy.

Here’s the rub: these forces are combining to cause CAP rate contraction. CAP’s are continuing to get lower, and while interest rates are being held at this artificially induced trough, it will not prove to be a problem. However, should interest rates begin to rise in the near future, many properties will no longer provide returns after debt service at the values we are seeing today. This will make it incredibly difficult for sellers to attract buyers for their properties! The only solution will be for sellers to accept dramatically lower sale prices than they are receiving today. Sellers unwilling to price cut will be unable to procure competitive buyers.

I believe this information will be of value to any owners who had plans to sell in the next three to ten years. There is no way to predict exactly when rates will rise, nor for how long, but it is absolutely inevitable that they will. Let’s all begin preparing now for what we know is on its way…

In the next 2 weeks I will be coming out with a series of posts with recommendations and thoughts for how to strategically prepare for this situation.

To a great 2012.

Included below are links to all of the 2012 Economic and Investment Real Estate Forecasts’ mentioned above.

Kevin Maggiacomo – “The Year Ahead – 2012″

Marcus and Millichap Research – Los Angeles 4Q 2011 Apartment forecast
- Oct 2011 Outlook – Apartment with Economy

Grubb & Ellis – 2012 Economic Forecast

Dr. Peter Linneman’s Winter 2011-2012 Linneman Letter

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Pepstein

So, let me get this thesis correct. As the economy improves, the fed will have to raise interest rates to combat inflationary pressures. This growth in the economy will also drive job growth, consumer spending, and overall investor confidence. Somehow though, the real estate market will see no sign of price appreciation, and prices will in fact decline due to the shrinking cap rate, decline even further than their already depressed state. And this is ultimately due to the fact that buyers won’t be interested in buying property at current prices (due to higher debt payments) and sellers will therefore be forced to “dramatically lower prices”. With all due respect, I fail to see that train of logic. The two ideas that growth will boost consumer confidence and spending but then consumers will not be interested in purchasing real estate due to higher interest rates are diametrically opposed. The same would have to follow for other credit purchases. So then the only way for this to occur would be for the fed to raise interest rates in a no growth climate, effectively artificially inducing a recession. As we’ve seen with Bernanke’s policies, inflation isn’t of concern – economic growth and unemployment are. He won’t raise rates until their are key signs of growth. And by that point, real estate prices will have to show appreciation as well.

http://www.ericamzalag.com/ Eric Amzalag

Thanks for the comment Peter.

I actually do not believe that broader economic growth will be significant. I think that 2012 will be much the same as 2011 – pretty much flat. Inflation is already a factor, and another year of FED policy holding rates this low will continue to stir those fears.

When interest rates do rise, sellers will be forced to lower prices to a point where investors can actually make a return on their investment after debt service. It will be a product of supply and demand – buyers will not buy until they can actually make a return, sellers will be forced to lower prices until CAP rates meet buyers needs, and then buyers will come back to the market. There will be a period where it will be a buyers market much like we are seeing with residential, but then as buying competition increases, sellers gain some of their influence back.

In summary, I think that this coming year will be a high point for apartment property values in Los Angeles. Multifamily has recovered nearly all of the value it had lost in the crash, but I do not believe it will return to those highs. This is an attractive time to be a seller. Values are good for owners who did not buy in the peak years (late 2007-2008), making now a great time to sell. Buyers can still find good opportunities, and even if they take a 10 year adjustable on a property they purchase today, chances are rates will have gone up and returned to a more moderate point as that ten year reset point approaches.

http://www.astudentoftherealestategame.com/ Joe Stampone

I generally agree with you Eric, but it’s worth pointing out that you’re talking about rental properties in core markets. These deals represent a flight to quality as well as an inflation hedge. It’s not simply a cash flow play.

We’re seeing a bifurcated recovery, so the story is much different in secondary and tertiary markets. While we’re beginning to see an appetite for stabilized property in B markets, investors are still hesitant to enter these markets. If you’re a strong operator and can lock in agency debt for sub 5% for 5 or even 10 year terms, it’s hard to go wrong.

I’m enjoying the posts and I look forward to following you as you advance in your career.

http://www.EricAmzalag.com Eric Amzalag

Thanks for the response Joe.

And you are completely right:
“We’re seeing a bifurcated recovery, so the story is much different in secondary and tertiary markets. While we’re beginning to see an appetite for stabilized property in B markets, investors are still hesitant to enter these markets. If you’re a strong operator and can lock in agency debt for sub 5% for 5 or even 10 year terms, it’s hard to go wrong.”

My next post will be about underwriting and how to use the artificially low interest rates to your advantage. It will be about the beauty of creating a detailed business plan from date of purchase. At least, I think its beautiful…