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Property Investors Eye Rising Rates But Keep Buying

The Federal Reserve's mixed messages on whether it will ease off the bond-buying accelerator or keep it floored are reminding commercial real estate investors that cheap money can't last forever.

For now, they're buying because they see profit potential even if interest rates for commercial property loans rise somewhat.

The Fed has expanded its balance sheet to nearly $3.5 trillion from $750 billion since early 2007 in an effort to reinflate asset values that plummeted in the financial crisis and recession. But reaction to suggestions in early June that the Fed would soon taper quantitative easing drove the 10-year Treasury yield from about 2.1% at the time to 2.7% in early July. Mortgage rates are tied to the 10-year note, and as interest rates rise, commercial real estate typically loses value.

Yields Not Yielding

The yield has remained elevated even as Fed Chairman Ben Bernanke and other officials throughout July expressed intent to keep buying bonds in light of the sluggish economy. Yet the Fed's reiteration of the policy Wednesday failed to keep the yield from climbing eight basis points to 2.69% on Thursday.

While commercial property mortgage executives anticipate a Fed pullback and rising interest rates in coming months, they still consider it a good time to buy real estate.

Why? Lending experts cite the historically high spread between 10-year yield and an average initial return, or capitalization rate. Consulting and valuation firm Real Estate Research Corp., for example, pegs the average cap rate of commercial properties at around 7%.

"I think if you're a buyer in the market today, a year out you're going to be glad you bought the deal," said William Hughes, managing director with commercial real estate mortgage banker Marcus & Millichap Capital Corp.

The 10-year note yield would have to approach 3.25% before it would begin to influence property pricing and value, predicts Brian Velky, a managing director with Real Estate Research.

What's more, major markets and those tied to energy and technology industries have enjoyed a healthy rise in occupancies, rent growth and other fundamentals. But other cities are experiencing improvements, too, albeit in choppy and plodding fashion. That has helped keep most buyers and sellers engaged as interest rates became more volatile, Hughes adds.

Positive Growth Signs

Despite a tepid office recovery, for example, 70 of the 82 markets surveyed by real estate research firm Reis (REIS) reported average office rent increases in the second quarter. Meanwhile, all 82 markets saw average apartment rents rise, Reis said.

Commercial property sales totaled $9.3 billion in the first half of 2013, a year-over-year increase of 12%, according to Real Capital Analytics. Sales totaled some $4.8 billion in properties in the second quarter alone, said the research firm, which tracks sales of at least $2.5 million apiece.

Lenders maintain that investment activity remains healthy, particularly among pension funds, real estate investment trusts and other big buyers focused on high-end properties in high-priced and competitive major markets. Those investors tend to pay all cash or finance their purchases with 50% to 60% of debt, so they are less concerned than other buyers are with movement of rates for financing.

Cash buyers alone accounted for nearly $1.1 billion in investment activity in the first half of the year, according to Real Capital.

But some smaller or private investors that use debt to finance 75% of their deals ran into snags. They typically seek loans through the commercial mortgage-backed securities (CMBS) market, which reacted more severely to the rise in yields than did conventional banks or life insurance companies, says Gerard Sansosti, executive managing director with commercial property mortgage banker HFF (HF).

Investors getting CMBS financing saw their mortgage rates rise about 100 basis points virtually overnight. "That kind of swing makes a big difference," Sansosti said. "It changes pricing.

In a few cases buyers and sellers had to renegotiate prices, Hughes notes. In others, buyers have reduced their loan terms to seven years, he says. Seven-year rates are about 60 basis points lower than 10-year rates, according to the U.S. Treasury. That difference saves investors financing costs over the long run and doesn't drastically raise mortgage payments.

Meanwhile, small investors who are able to secure bank loans have been largely able to avoid some of the rate fallout because banks have more discretion in moving interest rates, says Randy Fuchs, founder of Boxwood Means, a consulting firm specializing in assets of "small cap" properties of less than 50,000 square feet or $10 million.

Protecting Value

The threat of rising rates is unlikely to compel investors to rush into the market and lock in cheap debt while it's still available, Velky says. Instead, it's serving as a reality check, even among cash buyers.

Appreciation and income compose a property's total return, and ever since the 10-year yield hovered around 1.5% late last year, many buyers have been building yields of 3% to 3.25% into their valuation assumptions when pricing potential investments, he says.

The goal is to guard against value erosion amid interest rate hikes. As a property's value drops, he notes, rents must rise to maintain expected returns. Rents would have to grow by 4% to 5%, for example, to counterbalance a 25 basis point lift in cap rates, which rise as values fall.

"There still needs to be prudent valuation of investments because locking in low leverage is not going to offset the impact of rising interest rates," Velky said. "A 5% increase in rents is significant.

Show Me The Income

The Fed easy money policy has fueled rapid appreciation in most commercial property types. The value of real estate owned by institutional investors grew an average annual 9% over the last three years, nearly double the income contribution to total return, says the National Council of Real Estate Investment Fiduciaries. But real estate has historically been an income-oriented investment, Velky adds, so investors should dial down appreciation expectations.

"I think what real estate investors have to remember going forward is that 80% or maybe even 90% of your return will come from the income component," he said.