Capitalization Rates Leveling Off? 

Transactions have two sides—a buyer and a seller. While it is certainly pleasing to see how happy sellers have recently become as transactions are “priced to perfection”, we worry about the buy side where investors seem willing to pay almost any price to get into the game, and the feeding frenzy engendered by the “Wall of Money”, chasing yield and waiting on the sidelines seems to have no end.

Priced to perfection can easily turn into “priced to disappoint” as competition encourages investors to accept lower and lower yields as the price of entry. But our concern extends past the point of acquisition, as an investor can live with paying a little too much for a property by accepting a lesser initial return on investment.

Fast forward five years or so and perfection can easily turn into disappointment as the buyer faces a new property operating environment which includes the almost certainty of higher interest rates and more stringent lending criteria just as the post-last crises (2007+) class of properties come to the market in need of refinancing. While some argue that increases in net operating income (NOI) over the next five years will more than offset the higher costs of refinancing, others (rightly in our view) remained concerned about how fast NOIs will actually grow, given the fact that systemic vacancy rates today remain elevated across all property types. We all know that it is more than difficult to increase income (read: increase rents) unless and until you have occupancy.

An encouraging sign that investors may be becoming concerned about current pricing is the results (see chart below) of the Real Estate Research Corporation’s First Quarter 2013 Investment Survey which showed buy-side (investor) capitalizations flat or increasing for all food groups except regional malls, an anomaly easily explained by the lack of available investment product and the concentration of property ownership in the REIT space.

4Q 2012 (%)

1Q 2013(%)

Change (%)

Multifamily

5.40%

5.40%

0.00%

Office-CBD

6.10%

6.205

+0.10%

Office-Suburban

7.30%

7.30%

0.00%

Retail-Mall

6.40%

6.30%

-0.10%

Retail-Neighborhood

6.60%

6.90%

+0.30%

Retail-Power Center

7.10%

7.40%

+0.30%

Industrial-Warehouse

6/60%

6.60%

0.00%

Industrial-R & D

7.40%

7.60%

+0.20%

Industrial-Flex

7.70%

7.80%

+0.10%

Lodging

7.90%

8.00%

+0.10%

All-Property

6.85%

6.95%

+0.10%

One quarter is certainly not dispositive of very much and may only serve as a distinction without a difference. But, if this turns out to be the beginning of the “when” investors hit the speed breaks, many of our concerns will have been for naught (which is a good thing). Just one more trend to keep an eye on. 

Monday’s Numbers

The Trepp survey for the period ending April 8th showed spreads widening 5 to 10 basis points, averaging 173 basis points over 10-year U.S. treasury bonds, indicative of an all-in cost for high quality, moderately leveraged properties in the 3.50 percentage range. While there will be exceptions like the mall financings highlighted last week (two crème de la crème properties at 3.0 percent and even a little lower respectively), our view is that the financing market for trophy type property in core markets with strong sponsorship will remain range-bound at the current levels, waiting for one the “uncertainties” such as Europe’s economy, the Middle East, North Korea, etc. to upset the apple cart. Range-bound at 3.5 percent is not too shabby.

Asking Spreads over U.S. Treasury Bonds in Basis Points
(Ten-Year Commercial and Multifamily Mortgage Loans with 50% to 59% Loan-to-Value Ratios)

12/31/09

12/31/10

12/31/11

12/31/12

4/8/13

Month Earlier

Office

342

214

210

210

181

180

Retail

326

207

207

192

174

174

Multifamily

318

188

202

182

165

165

Industrial

333

201

205

191

171

165

Average Spread

330

203

205

194

173

171

10-Year Treasury

3.83%

3.29%

1.88%

1.64%

1.75%

2.00%

The Cushman & Wakefield Equity, Debt, and Structured Finance Group’s monthly survey of commercial real estate mortgage spreads for the period ending April 1, 2013 showed spreads for 10-year, fixed rate mortgages secured by Class A property, widening 5 to 10 basis points while spreads for Class B property came in similar amounts. 

10-Year Fixed Rate Commercial Real Estate Mortgages (as of April 1, 2013)

Property

Maximum
 Loan-to-Value

Class A

Class B

Multifamily (Agency)

75% – 80%

T +175

T +180

Multifamily (Non-Agency)

70% – 75%

T +175

T +180

Anchored Retail

70% – 75%

T +200

T +210

Strip Center

65% – 70%

T +220

T +230

Distribution/Warehouse

65% – 70%

T +205

T +215

R & D/Flex/Industrial

65% – 70%

T +220

T +235

Office

65% – 75%

T +190

T +205

Full Service Hotel

55% – 65%

T +255

T +280

Debt service coverage ratio assumed to be greater than 1.35 to 1.

In its analysis of current lending sources terms and conditions, C & W noted the following metrics which will assist potential borrowers in sizing loan requests:

Capital Source

Life Company / Pension Fund

Investment Fund / Finance Company

Money Center / Offshore Banks

 Conduits

Local / Regional Banks

Preferred Loan Size

>$10 million

$20-$100 million

$10-$100 million`

>$10 million

$3-$25 million

Cost of Capital

2.75% – 5.00%

5.25% – 7.50%

2.75% – 5.00%

3.50% – 4.75%

3.00 – 5.00%

Loan-to-Value

50% – 65%

55% – 85%

50% – 65%

Up to 75%

50% – 65%

Debt Yield

12% – 9%

12% – 7%

12% – 9%

10% – 8%

12% – 9%

DSCR

1.25x – 1.50x

0.75x – 1.40x

1.35x – 1.50x

>1.20x

1.35X

Other

Non-recourse

Non-recourse

Potential recourse

Non-recourse

Potential recourse

Prefer fixed rate

Floating rate or fixed via swaps

Fixed or floating

Fixed

Fixed or floating

3 – 20 year term

2 – 5 year term

2 – 5 year term; 10 year possible

5-10 year term

3- 5 year term; 10 year possible

Year-to-Date Public Equity Capital Markets

DJIA (1): +13.44%
S&P 500 (2): +11.41%
NASDAQ (3): +9.23%
Russell 2000 (4)11.01%
Morgan Stanley U.S. REIT (5):+12.18%
 (1) Dow Jones Industrial Average. (2) Standard & Poor’s 500 Stock Index. (3) NASD Composite Index. (4) Small Capitalization segment of U.S. equity universe. (5) Morgan Stanley REIT Index.

 

U.S. Treasury Yields

12/31/11

12/31/12

4/14/12

3-Month

0.01%

0.08%

0.06%

6-Month

0.06%

0.12%

0.09%

2 Year

0.24%

0.27%

0.22%

5 Year

0.83%

0.76%

0.70%

7 Year

1.35%

1.25%

1.14%

10 Year

1.88%

1.86%

1.75%

                                                  

Key Rates (in Percentages)

 

Current

1 Yr. Prior

Federal Funds Rate

0.16

0.10

Federal Reserve Target Rate

0.25

0.25

Prime Rate

3.25

3.25

US Unemployment Rate

7.60

8.70

1-Month Libor

0.20

0.24

3-Month Libor

0.28

0.47