Pricing Bubble Returns Again to Commercial Real Estate

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In DLA Piper’s annual survey of the commercial real estate industry, 85 percent of senior executives at commercial real estate brokerages, REITs, etc., hold a bullish outlook for the remainder of 2013.  56 percent see a combination of low interest rates and a abundant debt and equity capital as a primary reason for their optimism.  Only 40 percent named an improving US economy as a reason.

The Feds pledged to keep interest rates low until the unemployment number falls below 6.5 percent, which many analysts think won’t happen until late 2015 and to continue buying $85 billion per month in Treasurys and mortgage bonds to keep  long term rates low.

What happens, however, when the feds ease back on Qualitative Easing and interest rates get back to normal?  Due to recovery in capital markets, CAP rates are at or near historic lows for most property classes even as other fundamentals remain weak.

While it’s certainly a golden age for capital availability, it’s not so golden for real estate fundamentals, said Sam Zell, chairman of Equity Group Investments, during the keynote discussion at DLA Piper’s 11th Annual Global Real Estate Summit this week in Chicago.

“In terms of the cost of leverage, this is the cheapest cost of capital since the ’50s. But it’s not a golden age from a demand perspective,” the legendary real estate mogul and billionaire dealmaker told his audience.

Are we heading toward another mother of meltdowns as this bubble runs its course and interest rates rise?   Some of the threats sited are the potential for a midterm squeeze on liquidity when interest rates go up rapidity and the existing debts come due for refinancing.   Plus, the readily available low cost debt is encouraging loosening of underwriting standards.   I’m seeing this now with the number of deals that can get financed now that I couldn’t touch six months ago.  I think we all know where this will lead.  Didn’t we just go through this in 2008?

More than 68 percent surveyed in the DLA Piper survey think that CAP rates will hold steady while 20 percent feel that CAP will fall further.  A senior economist, John Kainer, with the Economic Research Department of the Federal Reserve Bank of San Francisco expressed concern with the disconnect between low cap rates and still weak fundamentals prompting concern that the low interest rate policy of the Fed may excessively boast property prices.   Record low CAP rates coupled with a quick run up in interest rates is a recipe for disaster …. again.

http://www.dlapiperresummit.com/export/sites/resummit/downloads/surveys/DLA_Piper_2013_State_of_the_Market_Survey.pdf