Report: Rising Caps Will Meet Stronger CRE

CALABASAS, CA-Rising interest rates, which the capital markets in general and the CRE industry in particular have been watching anxiously over the past few months, most likely will happen as the economy improves and the Federal Reserve begins tapering off its monthly $85-billion bond purchases. Yet in the long term the improving economy will boost CRE performance even as cap rates rise, says Marcus & Millichap in its fall capital markets report, which GlobeSt.com obtained exclusively in advance of its publication.

The tapering of the Fed's quantitative easing should mark a return to a more normal credit environment, wherein interest rates fluctuate naturally in response to economic and capital market drivers more than Fed intervention,” according to the report, written by Hessam Nadji, SVP and managing director with Marcus & Millichap Real Estate Investment Services, and William Hughes, director of Marcus & Millichap Capital Corp. “Many investors remain concerned, however, by the premise that a stronger economy, coinciding with withdrawal of Fed monetary support, will exert upward pressure on interest rates.”

This trend, many investors believe, “could instigate a rise in cap rates that ultimately undermines property values and weakens commercial real estate returns,” according to the report. “The context of this prediction, however, is far more nuanced than the math may suggest, with many variables other than interest rates influencing cap rate movement.”

As cap rates rise, though, the upward movement will benefit some asset classes while possibly cooling interest in others, at least temporarily, Hughes tells GlobeSt.com. “The biggest impact of an interest rate change will be in those really high-profile properties, A-quality properties in major markets,” he says. “The interesting thing about that is that we're finding that institutions are more interested in buying the asset for the sake of having that asset in their portfolio. I don't think most of the institutions that are in that marketplace have been overly concerned about getting the absolute perfect cap rate. It's about controlling the asset in that particular market, number one.”

The other assets that are impacted would be “credit-oriented properties,” says Hughes. “Those properties are pretty tightly wound, because you've got a credit tenant and those cap rates are pretty low, so you're actually purchasing the credit of the tenant. There's not a lot of wiggle room in those and so as interest rates go up, they're going to be impacted. For a period of time, investors will be moving to the sidelines and then ultimately come back into the market as things adjust.”

Conversely, however, Hughes says Marcus & Millichap has seen investors seeking higher yields moving “from the A-quality, B-plus quality down into the B-quality and even B-minus assets. We're also seeing investors become more open to some of the opportunities in the smaller markets—the secondary markets. I'm not sure we're seeing much pop” in the tertiary markets just yet.

Multi-tenanted buildings with shorter lease terms are also seeing some bump-up in appeal to investors. “It's easier to adjust to higher interest rates when you have those shorter-term leases with multiple tenants in strong markets where things are getting better and property fundamentals are improving,” says Hughes.

That's also why, "even though multifamily has been priced pretty expensively, we continue to see investor interest in that arena, because the elements of multifamily actually address that,” Hughes says. The short terms of most apartment leases give owners plenty of opportunities over time to increase rents, he points out.

When GlobeSt.com spoke with Hughes on Monday afternoon, the first shutdown of the federal government since 1996 seemed likely to occur the following day, but he foresaw “very little impact” on commercial real estate. “Last time, when Standard & Poor's changed the US credit rating, it shocked the market,” he says. “I think the market overreacted. We're less prone to do that now; we've been there and done that.”

Clearly, he adds, “everyone's concerned about a shutdown of the government; the government feeds a certain amount to the economy and certainly if they shut it down for a period of time it would be a drain against the economy. But I don't think anyone anticipates that it will happen for any length of time, so we're not expecting any major knee-jerk reaction.”