Industry Monitors Effects of Interest Rates and Economic Conditions
Commercial real estate is a capital-intensive industry in both public and private markets. Interest rates and spreads are key benchmarks for lenders in determining their cost of capital to borrowers. The industry also is dependent on the health of the general economy. As a result, savvy real estate professionals stay informed about — and make decisions based on — capital-market and economic issues beyond the commercial real estate industry itself. Recent trends in the capital markets and the economy may hold implications for future commercial real estate transactions.
Rising Rates and Spreads
Interest rates and spreads play an important role in commercial real estate purchases. Commercial mortgage rates frequently are based on U.S. Treasury securities that equal the length of the loan. The Treasury security is viewed as a risk-free investment with a specified return rate or yield. Lenders then add a spread (risk premium) in addition to the risk-free return rate to compensate for the perceived risk.
The combination of the Treasury rate and the spread generates the rate that a lender charges a borrower. If the underlying yield for Treasuries rises, the rate a lender expects to receive will rise as well, even if no additional borrower risk is perceived.
Influences outside of commercial real estate also may change spreads. This is particularly true for conduit loans that are originated with the intention of being securitized as bonds.
For example, when the Asian economic crisis struck the bond market in 1998, a so-called "flight to quality" took place. Treasury bonds — the most risk-free investment — became more desirable and valuable, while all other bonds became less valuable. Conduit lenders were caught in a situation where the mortgages they had committed to had less yield than the bonds they had to sell. To minimize their potential losses, many conduits renegotiated the terms of loans on which they had not closed. The situation rankled borrowers, but conduits did what was necessary to stay in business.
During the last five years, the recovery of the commercial real estate industry has shown a noticeable correlation to the decline of long-term Treasury rates. Capital not only has been available but also relatively inexpensive. However, long-term Treasury rates have shown an upward trend since the beginning of 1999.
As capital becomes more expensive, it will be increasingly difficult to employ leverage to achieve acceptable returns. Noninvestment grade property, which has relied heavily on securitized debt over the past few years, will be especially vulnerable.
Short-term financing, such as construction loans, is benchmarked from short-term rates such as the London interbank offered rate. Short-term rates are lower than long-term rates in a normal economy. When long-term rates rise, adjustable-rate debt based on short-term benchmarks such as LIBOR become more attractive. However, this carries the risk of becoming costlier than long-term debt if short-term rates rise significantly over time.
Actions by the Federal Open Market Committee, such as the February vote to raise its target for the federal funds rate to 5.75 percent and the discount rate to 5.25 percent — both 25-basis-point increases — do not actually raise mortgage benchmarks. However, due to the nature of the bond market, upward trends in short-term rates frequently result in higher long-term rates. While LIBOR does not move in lock step with long-term rates, it also has shown an upward trend over the past year.
Based on Federal Reserve Chairman Alan Greenspan’s February testimony to Congress, many economists consider it likely that there will be several interest rate hikes this year. Rising interest rates will make marginal real estate deals more difficult to close as underwriters place increased scrutiny on the financial viability of acquisitions and developments.
With a few notable exceptions, the performance of the commercial real estate market often follows the performance of the overall economy, with some degree of lag. Commercial properties derive their value from the businesses that use them, so when the economy performs well, real estate usually performs well too.
For example, retail properties derive a significant portion of their revenue from percentage rent. This makes their performance highly dependent on consumer spending. Also, office absorption is related directly to employment growth. Using macroeconomic trends as an analytical overlay to the real estate market allows real estate professionals to make more informed decisions about buying, selling, and leasing properties.
The growth of opportunity funds beginning in the mid-1990s is one example. Fund managers saw that the economy was improving and used their capital position to buy property at significant discounts. Later, after the properties had been repositioned to take advantage of improved economic conditions, the funds sold these properties for hefty profits.
The U.S. economy is entering its 10th year of growth, which is the longest period of expansion in history. Productivity continues to climb, and much of its increase is due to the rapid pace of technological change. While inflation is relatively benign at 2.7 percent for the year ending January 2000, the Federal Reserve is concerned about the economy’s continued growth. Changes in the nature of the economy, such as the growth of the stock market and the rising importance of the Internet, are causing the Federal Reserve to keep a close eye on the economy.
As the economy changes, real estate professionals also have taken advantage of business trends, for instance, the effects of e-commerce on real estate. Emerging Internet companies frequently are short on cash flow but may have significant upside potential. Some real estate companies have taken equity positions in dot-com companies in lieu of rental payments for occupancy costs (see this month’s Legal Briefs column).
The space needs of Internet companies often differ from those of traditional companies, and developers and landlords are accommodating these requirements. Warehouse size has increased, as has flexibility in lease terms. Dot-coms seek significant expansion and contraction options and shorter lease terms. How well developers and landlords protect themselves from the downside exposure of dot-coms will be key in how well the new economic strategies work.
Taking capital-market and economic trends into account when making strategic decisions may lead to enhanced real estate returns.