Interest Rates Drive SoCal Market Change

LOS ANGELES-The slow-but-steady rise in interest rates has squeezed already tight returns on commercial real estate in Southern California, producing a "disconnect" that will take a while to adjust, a new study concludes. Hessam Nadji, SVP and director of research at Marcus & Millichap, tells GlobeSt.com that cap rates "haven't responded yet" to recent interest rate increases but he expects to see them adjust over the next six to nine months.

With interest rates having increased about 60 basis points over the past few months, "You would expect a price correction that would adjust cap rates," Nadji says. However, that hasn't happened yet, so Nadji expects to see a "market transition" in the Southland this year.

The transition means that sellers will need to adjust their expectations on prices, Nadji says. To buyers, he says, "Don't overlook other Southern California investments where even a minor value add can improve returns significantly."

Southern California markets are among 45 nationwide for which Marcus & Millichap analyzed the returns and outlook for office, industrial, multifamily and retail investments in its latest study. Southern California responds to the same global forces that affect all markets, but the study also takes into account the regional forces driving the markets.

"The fundamentals in Southern California are basically stellar," Nadji says. Among others, he cites job growth, strong rents and absorption, and projections for continued demand.

But lest the Marcus & Millichap outlook sound too rosy, he cautions: "There are risks. The balance between NOI growth and interest rates is very delicate." The investment advisory and brokerage firm expects prices to stabilize on apartment and retail properties, with cap rates to continue compressing on office and industrial investments.

Nadji's study sees rent growth this year in all of the product types covered in the study, which looks at deals of $500,000 and up. On the higher end of the deal scale, where institutional investors play, Nadji says that one possible result of higher interest rates is an environment that could favor the institutional buyers.

"On the larger deals, higher interest rates might favor the institutional players by driving out private buyers who are more highly leveraged and therefore more sensitive to interest rates," Nadji observes. His study concludes that all classes of investments in the Southland should remain stable, and that the only course of events that might upset the stability "would have to be things that you can't predict."