ATLANTA—Competition for good deals is strong, helped by devaluation of currencies overseas. Investors, looking for better returns than they can get on a treasury or corporate bond, are rushing into real estate.
What will result from these market dynamics? That's what we asked KC Conway, credit risk manager and chief valuation officer at SunTrust Bank.
Typically, Conway told us, too much capital chasing too few deals increases prices to unsustainable levels that eventually return to historic norms. While the strengthening US dollar and declining value of foreign currencies—such as the Euro—are good for US commercial real estate demand and property values, he adds, they are putting downward pressure on cap rates and increasing property values at a pace that will eventually slow or unwind.
“As a result, refinancing risk is likely the biggest threat to investors in commercial real estate across the spectrum,” Conway says. “Historically, the long-term average cap rate for the four main commercial real estate property types—multifamily, office, retail, and industrial—has been between 8 and 10%.”
Drilling down, Conway explains that it's been 8% in good economic times and 10% in periods of oversupply or economic contraction. That long-held rule of thumb got turned upside down before the financial crisis when we saw the average cap rate for class A commercial real estate fall to around 6%, he says, and between 2007 and 2009 those rates shot back up to about 8% and wiped out 25 to 30 of commercial real estate values.
“The question all capital participants have to be asking today is: What is the refinance risk three to five years out?” Conway asks. “Who will take me out at the same or lower cap rate—or how much do rents and net operating income (NOI) have to increase to absorb the rise in cap rates? Investors and banks have to think about what the commercial real estate picture will look like when the environment normalizes and the Fed has raised interest rates.”
Want more insight from Conway? Check out his views on the impacts of the Basel Accords.
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