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All eyes on the fed

June 30, 2015

In March the Federal Reserve Board indicated that it was likely to raise interest rates at some point later in the year. With the economy improving but still fragile, the Fed suggested, the idea was to ease back to interest-rate normality (short-term rates have been near zero for at least six years). 

“We have been in a long period of Fed easing and Treasury buybacks to keep interest rates low so that the country could get growth back,” said Michael Phillips, a principal of Cincinnati-based Phillips Edison & Co. “Interest rates have been artificially low for quite a while, so you probably would get considerable agreement that in order for the market to not get overheated, we need some increase in the interest-rate environment over time.”

Considerable agreement there may be, perhaps, but total agreement hardly at all. First, not everyone in the commercial real estate industry believes that -interest rates will rise this year. Then too, historically, when interest rates rise, cap rates follow. But here again, not everyone is sure that will happen in such an orderly fashion if rates do go up this year. And third, if interest rates do rise, the effect on the retail sector is open to debate as well. In short, much like the Fed’s prediction for raising rates — hardly etched in stone — the potential effects of such a rate movement are guesswork, at best. 

“It’s not a foregone conclusion that rates will go up,” said Adam Petriella, executive vice president for capital markets at Coldwell Banker Commercial Alliance, in New York City. “There are a lot of subcurrents in the market that could preclude or prevent a rate hike. The ‘normal’ cycles are not normal.” Under the old normal, interest rates rise, cap rates follow, and prices decline. In this global economy awash with liquidity and structural issues, however, low rates may prevail, Petriella says. “The markets are as diverse as the needs of the buyers themselves. So, for instance, a foreign buyer or family office preserving capital is not necessarily as sensitive to rates as, say, a general partner or merchant developer for whom low rates help unlock creativity and value.”

But Brandon Harrington, a senior vice president at Walker & Dunlop, in Phoenix, thinks interest rates will rise before the end of the year. He points out, however, that those are short-term interest rates. Long-term interest rates are typically priced off the U.S. 10-year Treasury, which currently offers a higher yield than similar bonds in the U.K., Germany and Japan, making the investment very attractive to global investors. “Even if interest rates go up, because the rates for commercial mortgages are typically priced off the 10-year Treasury and there is a maximum amount of capital flowing to the Treasuries, we see this putting downward pressure on long-term rates,” said Harrington. And then there is the additional factor of investment demand for commercial real estate. “The normal reaction is that cap rates will rise if interest rates climb, but there is so much capital on the sidelines, the competition for product is intense, with more buyers than quality properties on the market,” said Harrington. “There will be a lot of pressure for cap rates to stay low.”

Cap rates in the first quarter continued to fall across all property types, according to Real Capital Analytics. Retail sector cap rates fell by 40 basis points to 6.4 percent, slipping below the previous low-water mark of 6.5 percent in 2007. All this varies by property type and location. Real Capital Analytics notes that cap rates for smaller markets averaged 7 percent, while the average cap rate at the six biggest markets fell to 5.6 percent.

If interest rates rise gradually, as many analysts expect, cap rates may not face tremendous upward pressure in the near term. “So what if interest rates go up 50 basis points,” said Kris Cooper, a managing director in the JLL Capital Markets Group, in Atlanta. “We are at historic lows. We are seeing lenders become more aggressive in terms of loan-to-value and interest-only periods. We are spoiled by the fact that interest rates have been low for so long. Even if interest rates rise by 50 basis points, that’s still one heck of an interest rate when you look at it long term over the past years.” Things change when interest rates rise, Cooper says. “But most buyers don’t look at it on a day one analysis; they are going to look at three-, five- or seven-year hold periods. Over the life of the loan, the fact that interest rates were x versus y at the time they acquired property is marginal. Even looking at the internal rate of return that is leveraged, it is just not that huge an impact. If there was a dramatic 300-basis-point rise in interest rates, yes, but there is no rationale in the economy to cause that much of an increase.”

In May 2013 the Fed announced that it would taper back its bond-buying program — or quantitative easing. This caused the yield on the 10-year Treasury to spike, upsetting markets in an event that has since been dubbed the “taper tantrum.” Among the victims in the turmoil were REITs, which analysts view as being as interest-rate-sensitive. Depending on how the Fed handles the interest-rate increase, the taper tantrum could be seen as a preview of what is going to happen, says Lawrence P. Casey, president and COO of Donahue Schriber, Costa Mesa, Calif. “The Treasuries went up 100 basis points over several months, short-term rates increased on the forward curve, and then REIT shares took a bit of a hit,” said Casey.

Rather than by earnings per share, REITs are valued based on funds from operations, which include interest expense, says Mark Bratt, a senior managing director at CBRE, in New York City. So if debt maturities are coming due with a low interest rate, and the new interest rate will be higher, that would affect FFO. Not everything is this cut-and-dried, however. “One of the reasons FFO has gone up is that interest expense has come down, but if interest rates go up, it will negatively impact the REITs from an interest-expense perspective,” said Bratt. “If interest rates are -going up and that is because the economy is stronger, then retailers do well. Retailer sales will improve, and rents will increase over time.”

Jim Costello, a senior vice president at Real Capital Analytics makes a similar point. “When interest rates increase, that is a sign of growth in the economy,” he said. “The rise comes because there is a demand for capital, which is needed for growth and investing.” Theoretically, if someone has an ownership in a large portfolio with very little debt, a rise in interest rates is unlikely to matter very much, he says. -REITs generally fit that bill, but they still could face share-price issues in a rising rate -environment. 

Phillips Edison and Donahue Schriber are among the companies adjusting to the prospect of an interest-rate increase. “On the construction side, in deals that we are doing right now, we are going for two-year loans with two one-year options,” said Phillips. “We are shortening the time on the short-term, floating-rate debt, and then, about a year after we have completed a new property or bought an existing one, we will look to fix longer-term debt through either the CMBS or insurance market.” By comparison, Phillips recalls that about 15 years ago, his company was doing three-year floating-rate loans on construction or acquisition with two one-year options. “We are shortening the old formula, the five-year horizon, because we think interest rates will increase over the next five years,” he said. 

Donahue Schriber is building a 900,000-square-foot power center in the northeast suburbs of Sacramento, Calif., and also using short-term, floating-rate debt. “We have always had a certain portion of our overall debt in short-term,” Casey said. “That’s because we have the luxury of a large portfolio-wide structure that is being held for the long-term. A single property developer has a much greater interest-rate risk. For us the overall portfolio of the company is weighted toward fixed-rate because of lower interest-rate-volatility risk, but we keep some of it in floating-rate because the interest rate is the best we’ve ever seen.”

Construction-loan risk can easily be minimized today, says JLL’s Cooper. “A lot of developers work a deal where the construction loan automatically swings into a semi or permanent loan,” Cooper said. “Today if you haven’t got that construction or semipermanent loan worked out, you will have interest-rate risk at the end of your construction cycle. The interest rate in two years won’t be the same as it today; it will be higher, and your yield will be lower.”

The same consideration is true for owners with excess assets in their portfolios. If a shopping center is well occupied and the owner has debt maturities coming due in the next couple of years, now is a great time to sell, thanks to low cap rates and potentially higher interest costs in the future, says CBRE’s Bratt. “Although it is difficult to pick the right time to sell, values today are 10 percent to 15 percent above 2007 values,” Bratt said. “Owners may look back at this period in two years and wonder why they did not sell more.” 

SIDEBAR: A rush to refinance
Since the depths of the recession, in 2009, issuance of commercial--mortgage-backed securities has climbed ever higher annually. In 2014 CMBS issuance reached $90 billion, and things look even better for 2015. By mid-April, CMBS issuance had totaled $36.9 billion, compared with $21.4 billion in the comparable period last year, according to Sean Barrie, a research analyst at Trepp, in New York City. What is interesting about the CMBS market is that a tsunami of CMBS loans will be maturing in 2016 and 2017: $120 billion and $124 billion worth, respectively. These are the biggest numbers ever, says Barrie.

Investors are looking ahead and realizing that the landscape will change when their loans hit maturity. Interest rates will be different, and the market may not be as salubrious as now. As a result, a lot of borrowers are refinancing loans, even though there may be a prepayment penalty. One of the more popular trends for borrowers looking to pay off loans in lockout is defeasance — “when the borrower substitutes new collateral for the loan in the form of Treasury securities that replicated the loan’s cash flows,” said Barrie.

“You would be shocked at how many people don’t have what they think they have in terms of a prepayment penalty,” said Adam Petriella, executive vice president for capital markets at Coldwell Banker Commercial, in New York City. “Sometimes the penalty is not as bad as they thought, and they realize if they were going to keep the asset another 10 years, it would be worth it to refinance and prepay.” 

On the other hand, “if someone has an onerous prepay and the loan is coming due in 36 months,” Petriella said, “there will be a higher interest-rate environment, and there is not much the borrower can do about it.”     — SB