Despite rate hikes, price rise expected.

What is it going to cost to buy a piece of commercial property in 2006?

Conventional wisdom says that rising interest rates will put a lid on real estate prices after several years of frenzied escalation. But more than a few in the industry believe that, at least in Southern California and the San Fernando Valley, real estate prices will continue to climb.

Limited supply, rising rents .rid continued demand could exert upward pressure on prices even as interest rates escalate, they say.

"Note that from 2000 to 2005 there's been this unprecedented upward movement in real estate values happening at the same time that fundamentals were weak," said Howard Stern, senior vice president and chief investment officer at Arden Realty Inc. "There are factors that will continue to support real estate values. One is capital flow, two is a favorable real estate environment and finally, high construction costs, so replacement costs and leasing going forward will propel price appreciation."

As recently as two years ago, a real estate buyer's unofficial yardstick was a cap rate around 7 percent on average for most properties, regardless of the sector.

But cap rates, a measure of returns on real estate investments in the first year of ownership, have been falling since then. Rental rates were not keeping pace with rising property prices, so with rental income flat and acquisition prices rising, the income yield dropped lower and lower.

Today, although there are variations for older properties and the rare bargain property that's been neglected, buyers would be happy to find a property selling at a 6 percent cap rate and many are settling in the 5 percent range.

"We don't see cap rates coming down substantially, nor do we see them spiking quickly," said Larry Scott, senior vice president for AvalonBay Communities Inc., a real estate investment trust that builds and holds multifamily properties. "We think that today's cap rates, although they are historically low, reflect a paradigm shift in investment activity. Investors are okay with cap rates in the 4 percent to 6 percent range where they would have been more comfortable with a 7 percent range historically."

The decline in cap rates has largely been driven by demand, which in turn was propelled by record low interest rates. Simply put, as the cost to carry properties declined, they became more affordable, even as prices rose.

Having fallen to a mid-three percent range, the 10 year treasury yield, on which mortgage rates are based, is now in the mid-4 percent range. Experts project that it is likely to climb to the 5 percent range before the end of the year.

But even that increase may not put a crimp in demand.

"As long as that movement is happening in an orderly fashion and is occurring along with improvements in occupancies and rents, it is not going to create a major disruption in the investment market," said Hessam Nadji, managing director of research services at Marcus & Millichap, which recently published an investor outlook projecting continued demand for investment properties.

Rental rates for all property types in the Valley are expected to escalate in the coming year, and with improved fundamentals, experts say, prices will remain elevated. Investors, they reason, will continue to view real estate as a stable investment opportunity so long as rents are rising and vacancy rates are low.

The outlook is the same for all property sectors.

Asking rents for office space in the San Fernando Valley remained relatively stable at about $2.15 per foot for most of 2005. But in that time, vacancy levels have declined to the mid-single digit range in a lot of markets. With virtually no new office product coming into the market, real estate professionals predict that rental rates will rise by 20 percent or more before the end of 2006. Already, newer buildings in Burbank and Westlake Village are commanding rental rates at or near the $3 range.

Rents have remained stable in the industrial sector for a number of years now. But experts predict that too will change as the supply of industrial space tightens further.

Continued industrial development in the Santa Clarita Valley was helping to keep a cap on rental rates, but those rates have been escalating as well, limiting the options for industrial tenants.

The situation is the same in the retail sector and the multifamily sector, where tightening supplies of space have already pushed rent increases in the 5 percent range in 2005.

"What's happening is leases are expiring and the leases are rolling into higher rental rates," said Eric Hasserjian, first vice president at Arden Realty. "Depending on the submarket, rental rates are increasing anywhere from 10 percent to 25 percent."

Nationally, prognosticators say that the outlook is less clear in the multifamily market, but those involved with multifamily investments in Southern California are not expecting a downturn anytime soon.

Here too, supply is extremely limited, and a continued influx of population virtually assures that rental rates will continue to increase.

"The unknown is job growth and how strong job growth is going to be," said Scott at AvalonBay. "But even a half of a percent of job growth in Los Angeles is a huge number of jobs. Short of job growth falling off completely, we like the prognostications for apartment fundamentals in the next two years in L.A."

With such exuberant predictions for rental and occupancy rates in the local area, many say that prices for properties will continue to rise, even with higher interest rates.

"The cap rates were driven low because of declining interest rates," said Thomas P. Bohlinger, senior vice president at CB Richard Ellis. "On the other hand, rents are increasing so rapidly that if you have a building that has significantly under market rents, but the leases are going to turn in the next three to five years, you may find people willing to pay a 5ish cap rate."