At 3.3%, long-term interest rates are near historic lows, despite a sizable jump in the past week. The economy should perform moderately better next year as two million private sector jobs are expected to be created compared to 1.2 million jobs in 2010 and 2.5 million jobs in 2012. The apartment market is in recovery, the retail property market is near bottom, and the industrial and office sectors appear poised to reach bottom by the end of Q1 2011. Spreads between interest rates, corporate bonds and real estate cap rates are near the highs of the past 20 years, resembling previous periods of market bottoms (1992, 1998 and 2002). This environment presents an investor with a window of opportunity that comes along only once a decade or so.
Today’s buyers have the advantage of locking in low-cost debt ahead of improving property fundamentals. The potential for a strong upside in 2012 and beyond is enhanced by several macro factors including, the lack of construction activity and the lag time between the decision to build, securing financing and the delivery of new product; the gap between sales prices and replacement costs in many markets; and the potential for rising inflation, for which real estate has historically proven to be an effective hedge. As the economy improves, more capital should come off the sidelines, out of the bond market and other safe vehicles, and flow into equities, real estate and capital expenditures.
This does not mean all is rosy. While interest rates are low, underwriting is tight and will likely remain so in the foreseeable future, making it difficult for borrowers to qualify for financing. There is a general shortage of quality properties being sold at distressed prices by lenders. Furthermore, slower-than-expected economic growth and unforeseen negative events pose additional risks to the lending market. A tepid recovery and high unemployment could result in gradual occupancy gains and rent growth, leaving room for disappointing cash flow improvement in the initial years of ownership. Looking further out, many investors are concerned about high interest rates eroding exit values.
The key to balancing the risk/reward equation is now more intensely driven by location and quality than last year when general fear resulted in more favorable pricing. The intense buyer competition for best-of-class assets over the past year to 18 months and the resulting re-compression of yields will likely result in broadening demand for Class B and B- properties in 2011. That is not to say demand for top-tier assets is going away. To the contrary, risk-averse, core asset-oriented institutional investors will remain active, as will REITs. But the trophy-yield compression means deals are becoming harder to pencil out, pushing the demand down the quality chain one or two notches. More risk-tolerant private investors and opportunity funds appear to be adjusting their return requirements and setting more realistic expectations now that the outsized yields sought through quality but distressed buys are out of reach. In terms of location, secondary but somewhat supply-constrained submarkets are more acceptable now than a year ago because confidence has improved. Proximity to jobs and high population density will still weigh heavily as investment factors. Full-scale, value-add plays, Class C assets and/or properties in tertiary locations; however, will still face significant challenges gaining buyer and lender acceptance.
The higher cap rates of B and B- properties in secondary, but relatively low risk locations, is set to become a bigger target for buyers next year thanks to low-cost financing and turning of the real estate cycle. (credit H. Nadji-Globe st)