Did Alan Greenspan ring the bell?

The dramatic rise in the market value of commercial/investment properties throughout the nation during the last 30 months has been primarily the result of historically low interest rates. While there were important reasons for bringing rates down and providing liquidity for the economy, I believe the Federal Reserve's policy of low interest rates has been overdone; interest rates have been held too low for too long. Government, corporations, consumers and real estate investors have been on a borrowing binge and appear to be captivated by low interest rates. The real estate market appears to be operating on the premise that low interest rates will be with us for quite some time, and to some extent investors are basing their acquisition and exit strategy on that premise.

We have been overdue for an interest rate reality check. Never in my lifetime (and I'm no youngster) have I seen interest rates this low with so much financing available for real estate deals. This heady mixture has me concerned. What happens to commercial/investment real estate values when rates rise and liquidity dries up?

There's an old saying; "they don't ring a bell announcing the top or bottom of a market." Well, I thought I heard one in March of this year when Alan Greenspan signaled that the benchmark short term interest rate (Federal Funds Rate) was poised to rise. At that time the rate was 1%. Since then, starting mid-year, the Federal Reserve Board's Open Market Committee has raised that short term rate four times, each by one-quarter of a point, to the current rate of 2%. They will meet again on December 14, 2004 when it is widely expected that they will raise the short term rate again by one-quarter point to 2.25%. Meanwhile, the 10 year Treasury Note, which in March of this year was at 3.83% (its lowest rate since June 2003, and one of its lowest rates in the last three years), was trading at its lowest spread verses both the Federal Funds rate (2.83% spread) and the average for fixed rate commercial-investment loans (1.90% spread). The relationship, or spread, between short and long term rates, especially the 5 and 10 year notes are important to real estate because these notes influence commercial/investment property interest rates. If the 10-year Treasury bond remains at its current level (4.39% as of December 2, 2004) or rises further, there will be a corresponding rate increase for loans used to finance commercial/investment real estate. Mr. Greenspan has indicated that he favors parity between the Federal Funds rate and the inflation rate. If that comes to pass, we might be looking at a 3.25% Federal Funds rate by the end of next year or in the first quarter of 2006. That would put the 10-year Treasury rate in the 6% range. The last time we saw that rate was in July 2000. Consequently that would put fixed loan rates for commercial- investment properties in the range of 7.75% - 8.00%.

If interest rates rise, so will CAP rates: because historically they move in the same direction. Rising CAP rates usually result in lower property values. Many markets continue to see record low CAP rates, so from my perspective they are vulnerable to a price correction if interest rates rise. Savvy Buyers like to have positive leverage when structuring a deal, but they will settle for neutral leverage for exceptionally good opportunities. Simply put, neutral leverage occurs when the CAP rate and the loan rate are the same. If loan rates go to 7.75% it's possible that CAP rates will also go to 7.75%. If that happens, where does it leave Buyers who closed deals with CAP's of 5% or less? The average CAP rate for closed deals in Los Angeles County for apartments in August 2004 was 5.72%, but many deals were closed at CAP rates at or below 5% in prime sub-markets. Granted there may be upside potential on rents and other factors that can raise net operating income (NOI), but there would have to be an enormous increase in NOI to offset the spread between a 5.72% CAP and 7.75% CAP. The increase in NOI will have to be on the order of 35%! And that's just to stay even with the increase in interest rates!!

Following is a summary of average CAP rates for 2003 and 2004 (through August) on closed deals in Los Angeles County for various property types:

According to this data it appears that our market may be vulnerable to a price correction if rates rise to the levels discussed above.

On November 20,2004 the Los Angeles Times published an account of Mr. Greenspan's comments at a banking conference in Berlin. According to the article, Mr. Greenspan issued a warning on the weakness of the dollar resulting from our nations bulging trade and budget deficits. He expressed his concerns in the clearest terms; going on to say that investors who weren't hedged against a rise in interest rates were "desirous of losing money". That's unusually blunt language coming from him (considering he usually talks in guarded terms). If I had any doubts about interpreting his signal back in March, they vanished.

Many factors and players influence the direction of interest rates, so there is no way to know how fast rates will rise, or if they will rise at all in the near term. Long term, it's a safe bet that rates will be higher than they are now. Mr. Greenspan and other Federal Reserve Board Governors have said they want interest rates to increase on a gradual, measured basis, spread over a reasonable period of time as dictated by circumstances. So if rates do increase, I believe they will do so in the time frames I described earlier in this article.

Real estate investors need to take a flesh look at their portfolios and their investment plans. They should assess the risks and rewards associated with their present investing strategy and factor in the probability of rising interest rates. Proforma statements and projections need to be closely scrutinized and assumptions questioned. Exit strategies need to be revisited. Existing financing on properties needs to be reviewed to insure "holding power" in the event rates rise and the market changes; short-term investments may turn into long-term investments. Refinancing needs should be assessed and plans made to avoid rate shock at refinance. Low interest rates made otherwise poor investments look good. Will they look as good if rates increase?

It appears that we are now in a transitional market; moving away from a shortage of available properties and an inefficient market where there were multiple Buyers for a property. The transition should be gradual. We expect an orderly transition to take place. Looking ahead, we see the 2005 commercial--investment market in Southern California as having the following characteristics:

Inventory--For a variety of reasons, disposition decisions will be made that were delayed or postponed due to dramatically rising property values. More properties will be coming to market as owners recognize that the best pricing levels may be behind us. This will offer more possibilities for exchanges, which played an important role in the appreciating market of the past 30 months. RE/MAX Commercial Brokerage is already seeing an increase in inventory in the Los Angeles County market. We monitor Los Angeles County inventory for apartments, office, retail and industrial properties on a monthly basis and have found significant increases in each property category starting in March 2004. We expect that trend to continue.

Pricing--There is a large amount of uncommitted capital available for real estate investments. This capital will be attracted to the market as CAP rates increase. We see CAP rates, and consequently pricing levels, directly reflective of interest rates. Over-priced properties will not sell and overbidding will subside. The market will be more evenly balanced between Buyers and Sellers. This will result in an active market generating more transactions, thereby providing many opportunities to investors. We believe Buyers will be looking at cash flow again and "Buy and Hold" strategy will take precedence over a "Bought and Sold" mentality.

Financing--We do not expect liquidity to dry up, but interest rates should rise. Loans, at historically attractive rates should continue to be available. We expect rates to rise gradually throughout the year, possibly reaching the levels discussed in this article. If interest rates increase, underwriting criteria will change. Debt coverage ratios and leverage will also change. Lenders will be cautious, but deals will still get done.

Brokerage Services--Brokers will become more important advisors to Buyers and Sellers. Over the last 30 months, Sellers had no trouble finding Buyers for their property regardless of price. With property values appreciating at a record clip, broker services were relegated to a somewhat secondary consideration. The transition market will elevate the broker's role in owner's / investor's decision making process. The importance, relevance and context of broker provided information and experience will be a significant consideration of owners and investors. Brokers will provide valuable services to their clients which thereby will promote an active, orderly market of informed investors.

Property        Average CAP Rate
Type             2003      2004 *

Multifamily     6.32%     5.72%
Industrial      7.48%     7.17%
Retail          7.77%     6.90%
Office          8.18%     7.47%

* Through August

Source: Costar COMPS.

Franklin M. Carone is President of RE/MAX Commercial Brokerage. He can be reached at 310-826-2221 (242) or [e-mail].