For commercial real estate investors, the good times may be over.
The Federal Reserve’s first interest-rate increase in nine years has removed a crutch that’s helped sustain 33 consecutive months of price growth of at least 10 percent and padded returns for buildings from office towers to luxury hotels. While values won’t necessarily fall, they aren’t likely to climb much higher next year, according to Tad Philipp, a commercial-property debt analyst at Moody’s Investors Service.
“A lot of the smart money is saying it’s a better time to sell than to buy,” Philipp said. “The warning light is on that the rate of appreciation is poised to decelerate.”
It’s a tenuous moment for landlords. Fallout from a protracted slump in oil prices and slowing growth in China are looming as borrowing costs slowly start to climb, threatening to crimp returns. Property investments have returned about 10 percent this year through September, according to the National Council of Real Estate Investment Fiduciaries, on pace to cap six years of double-digit gains.
Given uncertainty about the health of global financial markets, competing asset classes have been whipsawed this year. The Standard & Poor’s 500 Index lost 5.3 percent, including dividends, through the third quarter, while high-yield bonds lost 2.5 percent in the same period, according to a Bank of America Merrill Lynch index. The S&P 500 has since recovered, with a 3.1 percent total return this year through Tuesday, while high-yield debt is now down almost 5 percent.
“It is unusual for commercial real estate to outperform both stocks and bonds by such a significant amount,” said Jeffrey Fisher, a professor emeritus of real estate at the Indiana University Kelley School of Business who serves as a consultant to NCREIF. “In the long run, we expect real estate to have a return that falls somewhere between stocks and bonds.”
Property values have surged across the U.S., lifted by cheap debt, a global hunt for yield and a deluge of foreign capital seeking a haven. Commercial real estate prices now exceed the 2007 peak by 16 percent, according to a Moody’s-Real Capital Analytics Inc. index. Values for the most sought-after properties—including office buildings and apartment complexes in large cities such as New York—are about 60 percent higher.
The Fed, wary of bubbles amid seven years of unprecedented stimulus measures, is seeking to avoid inflating asset prices to unsustainable levels as it gradually lifts its benchmark lending rate from zero, according to Gennadiy Goldberg, a strategist at TD Securities. The central bank has repeatedly flagged commercial real estate prices as potentially showing signs of overheating. Earlier this month, in a joint statement with the Federal Deposit Insurance Corp. and the Comptroller of the Currency, the Fed said that lending in commercial real estate looked increasingly risky.
U.S. commercial real estate transactions climbed to about $546 billion this year from $432 billion in 2014, according to Real Capital Analytics. That compares with a record $575 billion of deals in 2007.
In 2015, there was a surge in blockbuster property transactions that rivaled some of the biggest deals from the last boom. Blackstone Group LP, in partnership with Canada’s Ivanhoe Cambridge Inc., this month acquired Stuyvesant Town-Peter Cooper Village—Manhattan’s largest apartment complex—for $5.3 billion, just shy of the $5.4 billion the same property fetched in a record 2006 deal. Prior owners Tishman Speyer and BlackRock Inc. defaulted on a $3 billion mortgage in 2010, marking one of the decade’s biggest real estate busts.
Rising interest rates won’t necessarily translate into lower property values, said Spencer Levy, an executive managing director at CBRE Group Inc., the world’s largest commercial-property brokerage. Climbing rents and an improving economy can justify higher prices even if borrowing costs increase, he said.
Foreign and domestic buyers are still sitting on piles of cash that need to be invested, Levy said. A new law eases taxes imposed on overseas investment in U.S. real estate, making it less costly for foreign institutions to acquire properties.
As of November, private firms targeting real estate in North America had raised $61 billion, a 42 percent jump from the same period in 2014, according to Preqin Ltd., a London-based research firm.
“Equity capital can provide a counterbalance to increasing costs of capital,” Levy said.
Still, the pace of price appreciation has already started to slow, according to Green Street Advisors LLC. While a rush of deals is expected to hit the market in January, the Newport Beach, California-based property research company is forecasting that commercial-property prices will decline about 5 percent next year, said Andy McCulloch, a Green Street analyst. The atmosphere “seems to be more tentative on both the debt and the equity side,” McCulloch said. “What that will translate to, nobody knows.”