As capitalization rates reach levels not seen since mid-2007, we start to wonder: how low can they go? Real Estate Research Corporation’s most recent survey shows average capitalization rates at 6.96 percent, down 0.10 percent from the prior quarter ended March 31 and within striking distance of the modern era’s all-time low of 6.50 percent, recorded in the second/third quarters of 2007.

Ten-year U.S. Treasury Bonds are trading at 1.50 percent, implying a 550 basis point spread or “risk premium” (6.96 percent average capitalization rates less 1.50 percent “risk-free rate). The obvious question is what is driving capitalization rates down.

While no one answer is dispositive, many analysts rely on the relative (or comparative) value with direct real estate cash returns and indirect REIT dividend rates far above comparable income-oriented investments. Leverage is another valid explanation. With borrowing rates so low (floor pricing is in the 4.0 percent to 4.5 percent range), literally any leverage is accretive to the equity’s return, thereby proving ample justification for what seems like paying up for property. Last, there’s so much capital ready for investment in real estate that investors seem willing to sanction their advisors paying up.

The question many are considering is what happens when interest rates finally go up. While that may not be until some time in 2014 (per the Federal Reserve) or possible later (per the state of the economy in 2014), the question remains: what will be the magnitude of the impact on cap rates of increasing interest rates. And collaterally, what will be the impact on values. Are some buying today to be disappointed when NOI growth is insufficient to offset cap rate increases?

Life Insurance Company Originations

According to Commercial Mortgage Alert, 2011 commercial real estate mortgage originations by the top 30 life insurance companies equaled $51.7 billion, a whopping increase of $18.4 billion or 55 percent over 2010 (and 2010 was up 39 percent over 2009).

The top 10 commercial real estate mortgage originators in 2011 were the following:

  1. MetLife
  2. Prudential
  3. Northwestern Mutual
  4. New York Life
  5. MassMutual
  6. John Hancock
  7. Pacific Life
  8. ING
  9. AIG
  10. Allstate

New Lenders Move in After Banks Retreat

The UK, Europe, and the U.S. share many things, one of which is a sizable amount of commercial real estate debt that needs to be refinanced. It is estimated that in the UK, there is £213 billion of debt secured by commercial property, 72 percent (or £153 billion) must be refinanced by the end of 2016. Obviously, this (and the impact of various regulatory regimes including Basel III and Solvency II) is putting a huge strain on origination and lending by commercial banks.

The strain of the funding gap appears to have provided an opportunity to an array of players including life insurers, pension funds, sovereign wealth funds, global investment funds, and the like to enter the real estate finance business. While insurance companies will remain very selective in their approach to lending, many of the new players are much more attuned to opportunities structured to take advantage of current circumstances including bridge and gap financing, preferred equity and mezzanine lending and the like.

Hopefully these new entrants into commercial real estate finance will be successful which will in turn prove instructive to other investors in markets such as the U.S. where we face similar issues with refinancing of existing mortgages.

Monday’s Numbers

The Trepp, LLC survey showed spreads widening as much as nine basis points during the survey period as volatility returned to the marketplace. We see the balance of 2012 range-bound by floor pricing (in the 4.0 percent to 4.5 percent range) by lenders.

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

12/31/09

12/31/10

12/31/11

7/5/12

Month Earlier

Office

342

214

210

238

233

Retail

326

207

207

229

229

Multifamily

318

188

198

222

222

Industrial

333

201

205

226

226

Average Spread

330

203

205

229

228

10-Year Treasury

3.83%

3.29%

1.88%

1.45%

1.92%

The Cushman & Wakefield Equity, Debt, and Structured Finance Commercial Mortgage Spread survey showed spreads for 10-year fixed rate mortgages unchanged during the survey period.

Property Type

Mid-Point of Fixed Rate Commercial Mortgage
Spreads For 5 Year Commercial Real Estate Mortgages

12/31/10

3/28/12

4/27/12

5/30/12

6/28/12

Multifamily – Non-Agency

+270

+230

+240

+250

+245

Multifamily – Agency

+280

+195

+200

+210

+225

Regional Mall

+280

+275

+275

+300

+300

Grocery Anchored

+280

+270

+270

+295

+295

Strip and Power Centers

+295

+295

+320

+320

Multi-Tenant Industrial

+270

+310

+285

+305

+305

CBD Office

+280

+295

+270

+295

+300

Suburban Office

+300

+310

+290

+315

+315

Full-Service Hotel

+320

+350

+340

+360

+360

Limited-Service Hotel

+400

+360

+350

+370

+370

5-Year Treasury

2.60%

0.83%

0.83%

0.69%

0.69%

Source: Cushman & Wakefield Equity, Debt, and Structured Finance.

Property Type

Mid-Point of Fixed Rate Commercial Mortgage
Spreads For 10 Year Commercial Real Estate Mortgages

12/31/10

3/28/12

4/27/12

5/30/12

6/28/12

Multifamily – Non-Agency

+190

+200

+210

+220

+220

Multifamily – Agency

+200

+165

+170

+190

+200

Regional Mall

+175

+275

+220

+245

+245

Grocery Anchor

+190

+270

+200

+230

+235

Strip and Power Centers

+290

+235

+260

+255

Multi-Tenant Industrial

+190

+280

+240

+260

+260

CBD Office

+180

+270

+220

+250

+250

Suburban Office

+190

+290

+245

+270

+265

Full-Service Hotel

+290

+325

+260

+295

+290

Limited-Service Hotel

+330

+345

+290

+320

+310

10-Year Treasury

3.47%

2.21%

1.95%

1.62%

1.58%

Source: Cushman & Wakefield Equity, Debt, and Structured Finance.

Property Type

Mid-Point of Floating-Rate Commercial Mortgage

Spreads For 3 – 5 Commercial Real Estate Year Mortgages

12/31/10

3/28/12

4/27/12

5/30/12

6/28/12

Multifamily – Non-Agency

+250-300

+200-250

+200-250

+200-250

+200-260

Multifamily- Agency

+300

+220-265

+220-265

+220-265

+220-265

Regional Mall

+275-300

+200-265

+200-265

+210-275

+210-275

Grocery Anchored

+275-300

+200-275

+200-275

+205-275

+210-275

Strip and Power Centers

+225-300

+225-300

+225-300

+225-300

Multi-Tenant Industrial

+250-350

+225-305

+225-305

+235-305

+235-305

CBD Office

+225-300

+225-300

+225-300

+225-300

+225-300

Suburban Office

+250-350

+250-325

+250-325

+250-325

+250-325

Full-Service Hotel

+300-450

+275-400

+250-400

+275-400

+275-400

Limited-Service Hotel

+450-600

+325-450

+325-450

+325-450

+325-450

1-Month LIBOR

0.26%

0.24%

0.24%

0.24%

0.24%

3-Month LIBOR

0.30%

0.47%

0.47%

0.47%

0.47%

* A dash (-) indicates a range.

Source: Cushman & Wakefield Equity, Debt, and Structured Finance.

Year-to-Date Public Equity Capital Markets

DJIA (1): +4.60%
S & P 500 (2): +7.88%
NASDAQ (3): +11.65%
Russell 2000 (4):+8.12%
Morgan Stanley U.S. REIT (5):+14.95%

(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

12/31/10

12/31/11

7/13/12

3-Month

0.12%

0.01%

0.09%

6-Month

0.18%

0.06%

0.14%

2 Year

0.59%

0.24%

0.24%

5 Year

2.01%

0.83%

0.62%

7 Year

0.98%

10 Year

3.29%

1.88%

1.49%

Key Rates (in Percentages)

Current

1 Mo. Prior

3 Mo. Prior

6 Mo. Prior

1 Yr. Prior

Fed Funds Rate

0.18

0.16

0.11

0.07

0.09

Federal Reserve Target Rate

0.25

0.25

0.25

0.25

0.25

Prime Rate

3.25

3.25

3.25

3.25

3.25

US Unemployment Rate

8.20

8.20

8.20

8.50

9.10

1-Month Libor

0.25

0.24

0.24

0.30

0.19

3-Month Libor

0.46

0.47

0.47

0.58

0.25