We read this very interesting article on commercial real estate and inflation from the CRE Console.
The article forecasts that cap rates will rise with treasuries as the economy continues to improve. This rise in caps and treasuries is expected to drive CRE values down an estimated 17% if the spread between the two remains constant. Even if the spread between cap rates and treasuries compresses a nominal amount, values will potentially still see double digit declines.
We agree with the article. We see cap rates rising with treasuries over the next 12-24 months. This rise will drive values of CRE properties down unless rents rise dramatically to offset the rise in caps and treasuries.
Article from CRE Console. Along with the assistance of @RESheets and @mcristia, I’ve put together a little graphic to examine the implication of a rising T-Bill and the effect it will have on commercial property values, particularly for those crazy trophy deals.
So, hang with me while I set the stage…..
As of March 31, Real Capital Analytics reports that the average cap rate is 7.16%, or about a 358 basis points above the 10-year US Treasury Bill.
PIMCO and others have openly said that 10-year T-Bill is artificially low by about 150 bps, due recent quantitative easing measures the Federal Reserve has undertaken.
As I write this, the 10-year treasury rests roughly at 3.50%, so I’ll use that as my base-case. Add 150 bps to that and PIMCO is saying the T-Bill should be at 5.0%.
Holding the cap rate spread constant (at 358 bps), that increase means the imputed cap rate would be about 8.58%. This increase would mean that commercial property prices would fall by nearly 17.5%.
But, if PIMCO thinks the T-Bill is overvalued by 150 bps now, what do they expect it to be this time next year? Say an increase of 200 bps from present day? A rate of 5.5% is not an outrageous assumption by any stretch of the imagination.
If that is the case, CRE property values could be down more than 22%.
Certainly, some would argue that spreads will compress, as interest rates rise.
As this interactive chart illustrates, even if spreads decline as the T-Bill rises, a sizable loss is still likely to occur. For instance the loss in value would still be 6.0%, if treasuries rise by 150 bps to 5.0% and spreads fall by 80 bps to 280 bps over the 10-year.
If spreads settle at 260 bps and the T-Bill reaches 5.5%, values would decline 12.5%.
So, how can trophy deals be trading for 6.0% caps, when they are almost certain to lose value in the future? The only remaining shred of hope is that real rental rates increase during the hold period.
The issue with this strategy is that most of these trophy deals are subject to long term, anchor tenant leases, which probably have fixed renewal options, even after the initial term expires. Therefore, there’ll be no exposure to this type of upside in these deals.
In addition, economic expansion and sustainable job growth is necessary for any real shot at rental rate increases. With the overhang in existing inventory, there will certainly be a lag between positive absorption and a point where this renewed demand pushes rental rates higher.
I’m not saying that there is a better place for your money than commercial real estate. The asset class has proven to fair well in prior inflationary periods. All I’m saying is that trophy deals may not be the way to go…
Instead, get creative with a more hands-on, value-added strategy.
For instance, buy a B+ building with some vacancy, renovate it to an A- with a dirt cheap bridge loan at 150 bps above LIBOR, undercut your competition’s asking rents to land a new tenant or two, refinance it, cash out your equity and repeat.
The O’Donnell Group is here to assist you with commercial development, property management, asset management and leasing.