Troon Funding Services http://www.workingcapitalforgrowth.net Providing Working Capital For Growth Fri, 07 May 2010 13:24:20 +0000 http://wordpress.org/?v=2.8 en hourly 1 Scarcity Is Driving Current Cap Rate Compression http://www.workingcapitalforgrowth.net/scarcity-is-driving-current-cap-rate-compression/ http://www.workingcapitalforgrowth.net/scarcity-is-driving-current-cap-rate-compression/#comments Thu, 06 May 2010 14:52:05 +0000 admin http://www.workingcapitalforgrowth.net/?p=237

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National News by Costar Group

Based on this recent blog post written by Mark Heschmeyer of Costar Group, Commercial Real Estate Investors are still navigating some choppy seas.   Some argue it is better to do something than to do nothing when managing funds and money, but what…

Remember when large institutional investors move, day traders will follow.  Thus creating bubbles on speculated futures.  Granted commercial real estate has long been the holly grail for sound investment strategies, and that is not likely to change any time soon.  But remember we all live in a much different world than those of our forefathers.

Why…  Let’s look at the explosion of the internet and secure access.  In years gone by, businesses had to support large office complexes to support it’s workforce giving them access to the main frame computer network.  Not today, we are much more mobile.  With a laptop, aircard and power, many corporate professionals will stay mobile leaving the Dibert world forever.

Let’s face it the recent downturn has pushed millions out of the workforce, and many are still looking for a way to reenter.  Corporations now have a global reach for talent and feel very comfortable producing goods and transmitting data throughout the world via broadband communication.   This is creating a corporate culture of creating partnerships for outsourcing labor as opposed to employing labor.  In addition, our thoughts are the new health care program and government mandates to recapture the runaway federal deficit are going to prove problematic in the coming years as the economy rebounds.

No matter how you look at this, there will be a new normal going forward.   I applaud the investors returning to the market, although long term success will only come with tenants filling the empty space.  That is where the rubber will meet the road.

My above comments are based on this article posted by Mark Heschmeyer of Costar.  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 - President

Angelic Real Estate  - New York, NY

My above comments are based on this article posted by Mark Heschmeyer of Costar.  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
President
Angelic Real Estate
New York, NY
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