With investment real estate trading at capitalization (Cap) rates close to their historic lows for most property classes, there is a growing concern that low interest rates may be driving commercial real estate prices to unsustainable levels.
That said, the Obama administration not only continues to support low interest rates, but is also pushing for lowering the qualifications for many borrowers of Fannie Mae and Freddie Mac backed loans. This is occurring despite the fact that such leniency in underwriting only recently led to the collapse of the housing market and the resulting $190 billion taxpayer bailout of those two agencies.
While the administration hopes to prolong the positive political impact of low interest rates, most real estate professionals appreciate that asset value is grounded on a property’s Net Operating Income (NOI). Where there is sustainable appreciation in asset value, it is typically the result of growing rents and improving occupancy married with efficient operations and cost control. With the exception of the multifamily sector, most asset classes have not fully recovered from the recent recession in terms of rents and occupancy, while operating expenses have often increased.
In the absence of improved real estate fundamentals, it becomes clear that the recent run-up in investment real estate values is being driven by Cap rate compression, largely attributed to the historic low cost of mortgage financing. The result is an asset “bubble” that will last only so long as interest rates remain at their current levels.
The Federal Reserve is inching back toward more market-driven interest rates, with Fed Chairman Bernanke recently hinting the bank could reduce its massive intervention in the bond market later this year. As interest rates inevitably begin to rise again, building owners may find it difficult to grow the property’s NOI fast enough to compensate for the impact of increasing Cap rates, and property market values will likely flatten out or may even drop commensurately.
For building owners contemplating a sale, the current market may present the best opportunity for profit-taking for some time to come. For investors considering acquisitions, it’s best to let the real estate fundamentals drive the decision-making process, rather than the current availability of low interest debt.