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Scarcity Premium Seen Driving Current Cap Rate Compression

With Little Quality Office Product in Play, Investors Vying Sharply for Low Hanging Fruit
May 5, 2010
Last year, capitalization rates on large office property sales rocketed from the mid-6 range to the mid-8 range. So far this year, cap rates have reversed course, falling back just as rapidly to mid-7 range. Under 'normal' conditions, this would imply that property values are increasing. So why isn't the commercial real estate industry elated?

Cap rates are a benchmark determined by dividing income by property value. Increasing cap rates typically imply that property values are falling. Last year, no one in commercial real estate doubted that the rapid rise in cap rates reflected an equal rapid decline in property values.

However, this year's decreasing cap rates, which would normally imply rising property values, are being viewed with some skepticism over whether they reflect a long-term trend in values, or simply a short term phenomenon.

According to Fred B. Córdova III, senior vice president / Investment Services Group for Colliers Asset Resolution Western regional team, the current cap rate phenomenon starts with that fact that there is two to three times more capital (debt and equity) in the market than there is product. That factor alone has pushed values up by 20% in three months, he said.

"There is a flight to quality NOI (net operating income) with a rational 'governor' that is price per square foot," Córdova said. "We are seeing some pricing here in Los Angeles (with cap rates) as low as 5% based on market rates. That said, there is a great deal of anxiety out there as to how far cap rates have fallen in the last six months. Foreign money is leading the charge."

According to Córdova, the current imbalance of available high quality office properties and the amount of capital seeking to invest in them has created what he calls a "scarcity premium."

"The market's fear/greed bipolar condition has created a scarcity premium that has pushed cap rates down by as much as 200 basis points, driven asset values up by 20%, for high quality, stabilized assets in submarkets with historically solid fundamentals in just three months," stated Córdova. "The only distressed properties that are coming to market are those with little hope of value recovery for the foreseeable future (more than three years). The most common examples of these are residential lots, followed by broken condo projects, apartments in markets with high unemployment and vacant unanchored retail properties. Neither the mini-bubble on the high end, nor the freeze on distressed asset transactions is sustainable."

Roy March, CEO of Eastdil Secured, also described the bifurcated activity in the current equity market focusing on either "trophy or trauma" assets.

"We began to see investors come off the sidelines in summer of 2009. After Labor Day, the depth of field for those bidders tripled, and we've seen it triple again in the first quarter," March said in comments during a panel discussion this week at DLA Piper's 2010 Global Real Estate Summit in Chicago.

The deepening pool of bidders has increased the certainty of closing deals, with due diligence and closing periods getting shorter. However, that is also putting upward pressure on pricing, he noted.

March echoed Córdova's view on the lack of quality assets coming to market producing a "scarcity premium."

"What we don't know is if this is a sugar high or whether we're going to see this as the new level of pricing," March said.

In the last few months, cap rates have tightened 100 - 150 basis points on the trophy deals relative to transactions focused on yield, he said.

"For non-stabilized assets, basis rules," March added. [Buyers] "are throwing away the yield calculation and looking at how much they're really buying it at, as a discount to either peak market or construction costs. That's drawing a lot of sellers back into the markets."

March said annualized sales volume is up 50% in 2010 versus 2009. Granted, the increase is more of a limbo than a high jump relative to 2009's dismal sales volume. But having said that, and looking at Eastdil's own transaction book as a market proxy, "we think [sales are] going to be at between 2003 and 2004 levels. We think it will be north of $75 billion in volume this year," March said.

March also said that projections for higher interest rates later this year are also driving the current market dynamic.

"There will be a big rush between now and the end of the year to get stuff to market and priced while interest rates are where they are. There's a lot of concern about interest rates going up post-election, and [sellers] want to take advantage of what they know today."

Robert Erlich, president of International Realty & Investment Inc. in Fairfax, VA, has been involved on both ends of deals involving 7% - 8% cap rates.

"I have been involved on two sales the last 11 months -- one as a seller of a multi tenant office building that sold at a 7% cap rate. I feel it sold for such a good price because it was a good location, it was where the buyer / user wanted to be and, with his lease in place, it was 100% leased and producing income. That was a $4.3 million sale," Erlich told CoStar Group. "The other property was a school that I purchased at a 8% cap rate and the reason I paid $7.625 million is that it is in a very good location and, it is 100% leased to a very strong educational tenant. I feel that the education industry is one of the few that have won the battle during the current economy."

However, Erlich does not believe the market has bottomed out for multi-tenant properties. "In this area there are still a lot of buildings that are in real trouble and losing tenants every day. (But,) "I do not think that buyers are getting too aggressive. I think competitive is a better word. There is just not a lot of quality product out there," Erlich said. "I do think that if you own quality, income producing product you are in the driver seat due to the shortage of solid product out there. I have been getting offers for some of our properties at a 6.5%-7% cap rate."

Outside of the "low hanging fruit," though, others in the industry believe negative fundamentals in the office markets are still ruling the office investment market.

David E. Thurston, director, NOIPG and Net Lease Group of Marcus & Millichap in Elmwood Park, NJ, said that the "sales that are closing that are driving the average cap rate to 7% -8% levels, are those that are in high demand and have multiple bidders, (namely) Class A properties in A locations."

Thurston added that if there were more buyers in the market - which there are not -- then more properties would be trading in the 10-12% cap range.

Scott D. Rabin, senior vice president of Edge Commercial LLC in Bethesda, MD, agreed.

"The volume of investment sales and time horizon is too short to see a real trend," Rabin said. "We need to see a sustained period (that is, four quarters or more) a higher volume of transactions before we can make a definitive conclusion. The spread is very thin between the cost of capital and the type of returns being accepted. Rents will need to rise and vacancy rates will need to fall for caps rates to hold on. I believe some buyers are being too aggressive but that most buyers are still seeking cap rates north of 8%."

What follows are additional comments from CoStar Group News readers regarding their take on the current office investment market.

Post Downturn Resurgence

"Value-add has yet to be redefined in this market, with market vacancy contraction not yet showing up, leaving ultra-opportunistic (vacant) property (particularly REO) as the only high-IRR money targets, and the rest of the world focused on Class A, tier-one and somewhat tier-two city product. I don't know that the second- and third-tier cities are necessarily doing significantly better or worse fundamentally, but the money that has gotten back in so far has definitely focused more on the core, Class A assets in top markets, which is typical of any post downturn resurgence in real estate investment.

"The $64,000 question is, what happens to investment real estate mortgage interest rates in the coming years? Overall values will be driving by the leveraged cash returns yielded by the lending side of the equation. Treasury rates will almost certainly rise, but spreads on real estate lending continue to compress. There are many borrowers that are willing to take 5-year money today instead of longer-term fixed rates, convinced that the future rise in benchmark rates will be offset by further spread compression, and that five years out we will have interest rates on mortgage loans that are similar to, or even less than, current rates.

"Some would argue that anyone that isn't yet back in the market has already missed part or much of the opportunity. Institutional investors generally realize that short of being purely market timers they are buyers and sellers in the same markets, up and down. The key is buying the right properties, or buying properties right, at any given point in the market cycle. The individuals and institutions that entrust these fiduciaries with money to invest generally don't do so expecting their fund managers to sit on the money for years at a time wondering what might or might not be the future, forsaking current cash returns in the meantime. At some point, there is more danger being out of the market than being in it - witness anyone that sold their stock portfolios in late 2008/early 2009."

Gabriel Silverstein
Angelic Real Estate
New York, NY

Get in Early

"Pent-up demand from excess capital seeking to meet portfolio diversification goals and seeking to participate in CREs fundamental recovery is driving the cap rate compression. Are buyers being too aggressive? Depends on their time horizon, the metro location they are investing in, the product type they are focusing on, and the specifics of the particular property or portfolio they are considering purchasing. If they're going in at 7% -8% NOI cap rate today, on real numbers, and if their horizon is 5-8 years, then in my opinion they are not too aggressive.

"If you believe, as I do, that 1) economic growth will continue, and that 2) employment will increase (creating demand for building space of all types), that 3) the Fed will keep rates reasonably low for the foreseeable future to stimulate the economy, and that 4) new construction will remain subdued (well below the "irrational exuberance" levels of 2005-2007) because so many "burned" lenders are still in business, then the answer is this trend will last. We have reached (or will reach in 2010) the bottom of the demand/price/value cycle for CRE in most property types in most U.S. metro markets, so, the next up-cycle is beginning."

Scott Kowalczyk
Kowalczyk & Co.
Marietta, GA

Don't Want To Miss the Bottom

I think buyers are too aggressive due to competition and lack of good supply. People don't want to miss the bottom with the promises they have made to investors. It will stay here for a while because things have stabilized but won't improve significantly for some time.

Doug Rittermann
Sales Associate
ECP Commercial
La Mesa, CA

It's a Crap Shoot

"Cap rates are coming down where occupancy is high and rents are reasonable. Remember that unemployment is still rocketing in many states. So office building investment is a real crap shoot from what I can see and hear and read. Cap rates are low because too much money is looking for quality deals but can't find quality properties that make any sense. So the money guys press on so they can keep their jobs at any rate and they drop that cap rate if they find a nice A or B class building where the elevators work."

Bob E. Nagel
Nagel & Co.
Atlanta, GA

Expecting Higher Interest Rates

"As a past Wall Street money trader I am very familiar with money rates. There are two factors that are driving cap rates presently. One is the expectation of forward [interest] rate increase. There is no doubt that the fed will raise rates, no less than by year end. And second, the five-year cycle of money lending will be coming up in 2011, with more than $500 billion of commercial loans coming due. The competition for money, both in the private sector and government to support the deficit, demands higher rates. This coupled with a moving target valuation model of what is the real worth of property requires a much more diligent approach to the future cost of money, or cap rate as you refer. There is also the "new" -- if not dusted off -- valuation method of "discounting" cash flow with lease rates on the downward cycle. Cap rates are reflected in both money stream evaluations."

Gerry Goldstein
Sales Associate
NAI Halford
Pensacola, FL

"I believe it is a function of low interest rates and the fears that future rates will go up. If you look at the prime rate over the last five years, we are extremely low historically. This combined with a very soft real estate market and some of the best per-square-foot pricing in a long time, tells investors it's time to buy some Class A space."

Brian Patton
Capital Realty Advisors
Atlanta, GA

Money Raised for Spending, Needs To Be Spent

"I don't see this trend as being due either to the market bottom or the cost of money. Foreign investors with patient money have invested, still regarding the U.S. as a stable real estate market relative to other choices. Another factor is some private equity real estate funds with capital raised two to three years ago needed to make investments per their fund agreements, or return the money to the investors."

Susan Lawrence
President & CEO
Real Estate Strategies Inc.
Winter Park, FL

Volume Is Up, Values Aren't

"I am seeing the opposite (trend) in transactions in the South Florida market for unanchored office buildings or retail from the $1 million to $10 million range. If anything, transactions have picked up but values have continued to slide. The reason that I believe we are seeing transaction volume increase is mostly because sellers are finally getting in line with what is undeniably the market values of their properties and are unwilling or unable to wait for an uptick in values. I will say, though, that we have reached a point where buyers are getting itchy trigger fingers with regard to "not missing the bottom" of the market."

Drew A. Kristol
Senior Associate | Member, Special Asset Services (SAS)
Marcus & Millichap
Miami, FL

Assumable Debt

"The lower cap rates are only showing on the highly occupied buildings with a long-standing track record of such. So if a building is in a great location with a long-term, good job outlook, I expect it will continue to be attractive to investors. A few points I've noticed here in Houston TX. If there is assumable, sub-6% CMBS debt on the property with 5+ years, buyers are responding. As these remaining terms burn off, I believe buyer interest will drop off, since replacement debt is very hard to come by, and not at a sub-6% rate."

Marty McAdams
McAdams Associates
Kingwood, TX

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