C’mon Lucky Sevens!
I am typically not one given over to speculation and hyperbole. I do not play the odds and I am no good at the casinos. However, let me be among the first people to point to the coming downturn in investment grade commercial and apartment properties. This has nothing to do with overbuilding as was the case in the 1980s or the drunken lending practices of the 2000s. This is purely related to today’s low interest rate environment.
Consider the bond market for ease of comparison. If you invest long term in low interest rate bonds, and then rates start to increase, the value of your bonds will decrease. The same principal holds true for real estate capitalization rates and commercial properties.
Let’s look at investment grade apartment complexes and office buildings as examples. For Class A properties, you have average cap rates between 4.5% - 7.5%, give or take. You also have had relatively little new construction over the past 5 years. Now that the future is looking somewhat brighter, coupled with stagnant supply and low rates, you have a high demand and low cap rate environment for these properties. As these properties are purchased, they are also typically financed to some degree with low interest rate debt that will have up to 10 year balloon payoff horizons.
Let’s now fast forward to the balloon payoff maturity dates. In 10 years, I think it is reasonable to assume that interest rates may rise from 4.5% to 6%. That is still a low rate. However it is a 33% increase. If cap rates increase by 33% as well, this will have a huge negative impact on property values. In order to keep pace, net rents and income would need to increase by 33% in order to just maintain net property values. That is not going to happen without some serious inflation. So, when the mortgage note balloons, cap rates will be higher, property values will be lower, and the cost of replacement capital will be more expensive with less replacement debt available due to the lower property values. Viola! Another real estate downturn for opportunity funds to swoop in to purchase properties that may have trouble recapitalizing their debt.
The term buy low and sell high never loses its meaning. In today’s low interest and cap rate environment, I am concerned that too much institutional money is buying real estate too high for their own long term good. But, then again, maybe I am wrong. After all, some people never stop rolling sevens, right?
Until next time…
Keep kicking the dirt!