The Impact of Rising Interest Rates on CRE Values

We all often hear how increasing interest rates are affecting values. Many are saying “How does this affect me?” Such a broad statement without specifics and substance can easily be dismissed. We thought we would drill down deeper and provide you with some examples of exactly what it means for commercial retail investment property owners like yourself.

The market, generally speaking, was on a “Bull Run” for six years – from 2011 to the end of 2016. We are and have been in a post-peak market since December 2016 and values have certainly been negatively affected. During that six-year period, our clients loved meeting with us and allowing us to perform a strategic analysis for their property on an annual basis. We consistently delivered positive news which stated, when their property generally didn’t change, that their property gained value year-over-year.

In the fourth quarter of 2016, we emphasized there was a large indication and degree that the market was at its apex. Their investment property, at that time, had peaked in value and if they were to consider a disposition, this time would most likely yield them the highest price. Many expressed that they believe that values will continue to climb and they will hold to reap that benefit.

Since that time, we have reflected on the past two years and determined that at that moment in time, it indeed was the peak of the market. Our team also heard similar investor sentiments in 2007 and early 2008. Many investors echoed the same stance in stating that they still believed that they could yield another 5-10 percent from that point in time and will exit in a year or two. Upon revisiting with many of those clients, the majority have expressed to us that that turned out to be one of the biggest mistakes of their lives. While, let us be clear, in no way are we predicting a collapse of that magnitude; we don’t have a crystal ball. Instead, we use the cycles in history combined with the current market and economic conditions to guide our future projections.

What we do know is this: Market cycles, over time, typically last between 9 to 12 years. If the fourth quarter of 2016, based on values reaching a plateau was this cycle’s peak, then we have another 7-10 years of downward pressure to withstand.

You are probably asking how this affects you? We have decided to provide a few specific examples of recent properties that we provided valuations on over the past
three years. We also coupled this with a simple table that illustrates what the debt service will be in the upcoming years and how this translates to cap rates and values.

Our objective here is to continue to inform our clients about how interest rates are affecting values for retail commercial properties.

The below examples are properties that have maintained the same occupancy percentage, tenancy and lease lengths.

Example 1:

  • Charlotte County,  Florida
  • Neighborhood Shopping Center
  • 32,000 sq. ft. / 12 tenants / Class B+
  • Change in Value:
    • December 2016: $3,925,000 / 6.75% cap rate
      • November 2017: $3,760,000 / 7.05% cap rate
        • September 2018: $3,600,000 / 7.36% cap rate

An overall decrease in value of 61 basis points (.61%) which equals $325,000 in less than 2 years

Example 2:

  • Lee County, Florida
  • Grocery Anchored Shopping Center
  • 91,000 sq. ft. / 16 tenants / Class C+
  • Change in Value:
    • August 2016: $12,375,000 / 7.03% cap rate
      • September 2017: $11,966,472 / 7.27% cap rate
        • November 2018: $11,298,221 / 7.70% cap rate

An overall decrease in value of 67 basis points (.67%) which equals $1,076,779 in just over 2 years.

The below table also illustrates the picture very clearly for a two-year forecast. It relates to rising interest rates and increasing cap rates and how they directly translate to the decreasing price and price per square foot for a $2,500,000 retail asset:

Change in Value - Shopping Center.PNG

Most active investors acquire a mortgage for a commercial retail property purchase. Interest rates have risen 120 basis points (1.2%) in the past 24 months and will increase a forecasted 75 to 90 basis points (.75 to .9%) in the next 12 months. If said investor requires a 250 basis point (2.5%) spread between their mortgage interest rate and cap rate or to maintain a specific cash on cash return, as many investors do, that means that the strike price decreases as time moves throughout the upward cycle.

This is exactly what we have been seeing.

Let’s also be clear on a few additional factors. First, there is not a one-for-one point equality between interest rates and cap rates – which is a positive. Second, the increase in cap rates do not immediately follow the interest rate increases as there is often a 6-12 month lag time or delay that follow interest rate hikes. That lag time can also be dependent on the cash supply in the marketplace and demand for properties on the market.

The simple principle to understand, however, is that prices are derived from cap rates of verifiable arm’s length transactions of similar kind properties within a very brief period of time. If the cap rates of these sale comparables increase, then the value of your property is negatively impacted and also loses value, even though your property itself has not changed. It is a factor of the economic conditions and market changes due to the rising cost of debt.

We are recommending for you to frequently assess your property and understand the cycle and it’s many effects on value. We are communicating to our clients that if they plan on holding their asset at this time, then we suggest holding long term, at least seven years, to land on the other side of this cycle where values will likely be again stabilized. However, if an investor is considering a disposition and exit from their current income producing commercial retail property within the next few years, it is advantageous to exit sooner rather than later to maximize value.

Many of our clients who stated that they would never sell are now considering a disposition. Others who were on the fence are now bringing their property to market to capitalize on their equity. We are also transitioning many of our multi-tenant property clients through a strategic 1031 exchange into other asset types. Some investors are targeting stable net-leased passive assets in which the lease term expires well beyond the end of this cycle to mitigate the risk of their cash flow stream and pairing these long-term stable assets with deals that have more upside in order to obtain a better average yield. The whole purpose, however, is to mitigate risk of the current equity/cash flow stream, while getting them over the impending market shift and allowing them to take advantage of the more-favorable market and lending conditions that will exist at that time.

We not only specialize in maximizing the value and commanding the absolute highest price for the properties that we sell for our clients, but also in transitioning them into a safe landing spot with an equal or greater return. We exclusively represent these same clients as buyers through their exchange period and are extremely successful in yielding them the property that meets their criteria and return requirements. We look forward to hearing from you and working with you to assess your property and provide all of the options available to you. We then pair this with our recommendations which are also influenced by the client’s goals and existing market conditions.

Below are some historical facts as food-for-thought to conclude this article:

Historical Realities

  • Interest rates have been steadily rising since 2015.
  • The Federal Reserve just completed its eighth (8th) rate increase over the last three years bringing the Federal Funds rate to a targeted level of 2.25%. Moderate increases are expected to continue in 2019.
  • Strong economic growth fueled by lower taxes, increased spending, reduced regulations, low unemployment and higher consumer confidence has helped drive the 10-year treasury to 3.19% as of 11/06/18.

Federal Funds Rate.PNG

Economic Growth

  • Strong economic conditions and overall NOI growth should at least partially offset the impact of rising rates.
  • NOI growth was very strong in 2017 at approximately 5.3%. Forecasts for 2018 and 2019 are 3.70% and 3.90% respectively.
  • This compares to an average of 3.20% per year over the last 20 years.
  • It should be noted that a 4-5% increase in NOI is needed to offset a 25bps increase in cap rates.
  • Furthermore, an NOI increase of 8-9% is needed to offset a 50bps increase in cap rates.
  • As we get later and later into the current RE cycle, the risk that NOI growth will not be able to keep pace with rising cap rates becomes more pronounced.

 

We welcome the opportunity to pair our expert insight with more specifics about your situation and properties. We understand that even though now is a good time to sell for some, it is not the right time to sell for many. With that in mind, we pride ourselves in building long-term relationships and our intention to help you execute on your long-term investment strategy by providing our insight today; even if that means we will be providing insight for many years to come before we facilitate a transaction. That is why most of our clients become repeat clients in the future.

Let us know how we can help and we look forward to helping you in any capacity that makes the most sense for you and your goals.

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