Due to an over-abundance of capital combined with a lack of inventory, we are seeing a continued compression in cap rates while borrowing costs rise, says Kozakov.<@SM>As borrowing costs continue to rise and the upcoming wave of CMBS debt becomes due to mature over the next 24 to 36 months, we will see an upward adjustment in cap rates, says Wade.

LOS ANGELES—Rising interest rates and cap rate compression:  how long can this continue? We’re hearing these questions a lot these days: “What is the 2014 outlook for cap rates and interest rates?  When will cap rates start rising again?” 

In an exclusive GlobeSt.com interview with Los Angeles-CBRE’s first vice presidents Alex Kozakov and Patrick Wade, who co-lead a retail investment sales team based in Downtown Los Angeles, the team commented on the continued compression of cap rates. “Cap rate compression while interest rates slowly continue to rise is a rare occurrence for commercial real estate,” the team says. 

GlobeSt.com: Why are cap rates compressing as interest rates slowly rise? 

The CBRE team: Historically, as borrowing costs have risen, cap rates have increased along with them.  Today, however, due to an over-abundance of capital combined with a lack of inventory, we are seeing a continued compression in cap rates while borrowing costs rise. 

There are four significant causes for this:

-       A seemingly never-ending flood of capital and a lack of quality supply (particularly net-leased credit tenants in areas with dense populations and solid demographics) creates a lack of internal investments.

-       We’re continuing to see high net worth families and trusts become tired and frustrated as they hold their money in banks and watch it earn less than 1% interest every year.  Due to this search for a return, investors have continued to aggressively price assets and have been more tolerant to risk throughout 2013 and the beginning of 2014.  Credit tenant net-leased investments provide an alternative yield opportunity typically between 4 – 5%.   

-       Foreign capital continues to see US real estate (compared to investments in their home country) as a safe haven due to the relative stability in the government and real estate markets, and because of this, they are willing to pay much higher premiums to own assets they believe will be a safe, solid investment for themselves and their families for many years to come. 

-       Multifamily properties have also been trading at all-time lows, and we are now seeing many exchange buyers depart from this product type, seeking management-free, passive investments that they can hold long-term without having to put in a large amount of effort to maintain. 

GlobeSt.com:  What are some specific examples of this that you’ve seen in the market? 

The CBRE team: During the course of the past year, we have seen extremely low cap rates and aggressive prices per foot with our own properties.  For instance, in the past couple of months, our team has sold two net-lease Chase Banks in Los Angeles County at record-setting cap rates below 4.5% and over $1,000 per square foot.  We also sold a net-lease Starbucks at a sub-4% cap rate for over $2,000 per square foot. Recent multi-tenant sales included a Starbucks-anchored strip center in Oxnard and a neighborhood shopping center in Van Nuys, both of which achieved prices well in excess of $400.00 per square foot.  All of these deals sold all-cash. We are continuing to see cap rates compress as investors strive to obtain properties they believe are safe yet profitable investments. 

Retail assets led all commercial property types in terms of price appreciation in 2013, up more than 23% for 2013. The national average cap rate for retail properties continued to compress during Q4 2013, dropping by slightly more than 59 bps on a year-over-year basis to reach 6.5%. Moving forward, CBRE Econometric Advisors projects that the yield on the 10-year US Treasury will reach approximately 4.5% by 2016. Such inflationary pressures will inevitably place upward pressure on cap rates, but commercial real estate has generally been considered an appealing inflationary hedge. As such, retail assets should continue to attract strong investor interest as the spread between cap rates and US Treasury yields normalize.   

GlobeSt.com: This can’t last forever. What are the possible outcomes? 

The CBRE team: Much will depend on the Federal Reserve policy. At the end of last year, the Fed announced that it will begin to taper asset purchases with a reduction in the rate of instrument purchases—by about 12%.  If the economic recovery stays on track, the Federal Reserve will continue these reductions in the rate of its purchases. This implies that longer-term interest rates will continue to increase during that period. 

In our opinion, we will continue to see the same trend over the next twelve months. As long as there is a limited supply of investments in the market and a lack of alternative investment options in the financial market, investors will continue to look at commercial real estate as a viable option, which will allow cap rates to continue to compress.  However, as borrowing costs continue to rise and the upcoming wave of CMBS debt becomes due to mature over the next 24 to 36 months, we will see an upward adjustment in cap rates.