Spreads May Widen If Rates Rise Further

Capitalization rates, or cap rates, in the U.S. commercial real estate market have begun to ratchet higher, according to market participants. Some industry observers believe these higher cap rates may already be impacting property values.

Also, while cap rates have risen slightly, the pace of lending in the commercial property world has not been affected. In fact, lenders report that there are still abundant sources of money, from both domestic and overseas backers, that companies are willing to put to work.

Higher cap rates, market players say, should not come as a surprise, considering the series of U.S. Federal Reserve interest rate hikes seen in the last two years. The nation's central bank first started raising borrowing costs in June 2004, when the federal funds rate was at 1.25%. Now, 17 quarter-point hikes later, the federal funds rate is at 5.25%. This, in turn, has increased the cost of money for anyone looking to borrow funds for a commercial property purchase or refinance.

‘I think [cap rates] have to be tied to interest rates,’ says Roger Lehman, co-head of U.S. rates and structured credit research at Merrill Lynch & Co. Inc. ‘You cannot have rates go up 400 to 500 basis points without cap rates rising.’

The series of interest rate hikes by the Fed has steadily tugged U.S. Treasury yields up. While lenders use a variety of benchmarks for their loans, the 10-year Treasury yield is commonly used as a reference point. In late August, those yields were at around 4.8% – down from around 5.25% in June.

‘Our cap rates have definitely gone up,’ comments Kevin Fuko, president of The Altair Group, a commercial real estate broker and real estate consultant based in Neptune, N.J. ‘There definitely is a major change in them.’

‘We have seen them rise,’ adds Alan Todd, head of commercial real estate research at JP Morgan Securities. ‘It depends on the property type and the particulars of a given loan.’

According to Fuko, the rise in cap rates has already had an impact on values, even though there are many willing lenders with ‘a lot of cash’ to finance transactions. The change in cap rates has been evident in the last six to nine months, and it has slowed appreciation of property values, he says.

‘Yes, it has impacted values already,’ Fuko remarks. ‘We are not seeing a drop in value, [but] people are not overpaying for things anymore.’

However, he notes, the hospitality segment of commercial real estate has not yet seen as much of a rise in cap rates – something that may have more to do with strong gains in occupancy rates – but cap rates are, surprisingly, up slightly for multifamily transactions.

JP Morgan's Todd points out that while cap rates are up, the rise is not uniform. ‘It is property- and location-specific,’ he says. Top-quality property loans in areas such as New York are still commanding low cap rates, while cap rates for smaller properties are softening in secondary and tertiary markets.

Fuko notes that the rise in cap rates was likely first evident in February or March. The higher cap rates were surely tied to the ongoing interest rate increases put into place by the Fed, but higher energy prices have also stirred talk about inflation and the prospects of a protracted anti-inflationary stance by the Fed.

Some market participants believe that while cap rates have risen, they may not match previous levels because investors feel more comfortable with the asset class, and there are more sources of money readily available to finance deals. Also, rating agencies and other market participants, such as Wall Street lenders, have become a part of underwriting – adding transparency to the process.

‘We can see who is doing well and not doing well,’ says Anthony Gramza, a mortgage broker at AMG Commercial Mortgage Brokers, Penfield, N.Y. ‘[Investors and lenders] can look back. They have a history.’

Gramza is not alone in his belief that the cap rates may not match levels of the early 1990s. ‘In previous rate cycles, where we have had a seven percent Treasury 10-year note rate, a lender may have wanted to see a 10 percent yield,’ Merrill Lynch & Co.'s Lehman remarks.

‘So, that lender wanted to see a spread of 300 basis points for taking on that real estate risk,’ he says.

In the current market, with Treasuries at around 5%, cap rates are at 6.5% to 7%, depending on the property type. This gives lenders a spread of merely 150 to 200 basis points, which suggests that lenders are willing to accept a lower return.

But Lehman warns that this spread may widen if rates rise further. For example, if we see a 7% Treasury note yield, then we could see cap rates go up to 8% or 9%.

All things considered, what are lenders and borrowers seeing when it comes to commercial property finance terms?

According to Gramza, a multifamily property loan with an 80% to 90% loan-to-value (LTV), fixed for 10 years with a 30-year amortization schedule, could be priced at 165 to 185 basis points over 10-year Treasury yields.

An office property loan with a 75 percent LTV, fixed for 10 years with a 20-year amortization schedule, will likely have a rate of 200 basis points to 250 basis points over the 10-year Treasury note.


Florida Firm Joins Network

NAI Global, a network of independently owned commercial real estate brokerage firms, has extended its coverage in the Florida panhandle with the addition of NAI Emerald Coast in Panama City.

NAI Emerald Coast is a new brokerage firm founded by William B. Fenimore, who previously was a broker at NAI Halford, northwest Florida's largest full-service commercial real estate firm. NAI Emerald Coast specializes in office, industrial, and retail leasing and sales, investment property and land deals, and tenant representation and site selection for corporate clients.

‘Bill Fenimore has extensive experience working with both local clients and our many clients outside the market,’ says Jeffrey M. Finn, NAI Global's president and chief operating officer. ‘The addition of NAI Emerald Coast strengthens our coverage in this important area of Florida.’

NAI Emerald Coast's clients include Hughes Supply, Bechtel, Grey Bar Electric, Science Applications International Corp., BF Goodrich, Value Place, AT&T Communications, Safeway, Emerald Coast RV and Watermark Development.

‘Being part of NAI Global gives NAI Emerald Coast the international credibility and prestige to stand out in a smaller market,’ Fenimore says. ‘Our strong connection to other local market experts worldwide enables us to bring more value to our clients.’

Expands Project Development Biz

Stamford, Conn.-based GE Real Estate is expanding its project development business through the company's vacation ownership finance group. The product line features larger-sized acquisition, development and inventory loans, a streamlined approval process and market-leading pricing on all its financial solutions to the timeshare resort industry, the company says.

‘We're excited to offer a full complementary line of products, combined with a streamlined approval process and competitive pricing to growing developers worldwide,’ says Mike Coen, managing director for the group.

With the improvements, GE now offers a fixed- or floating-rate notes receivable loan program, and a fixed-rate notes receivable securitization program for tax advantaged off- or on-balance sheet transactions. And according to the company, the improved vacation ownership program offers developers efficient execution. CMI



WHAT: This retail property is improved with one strip retail building that is occupied by 16 tenants, including RadioShack, Boston Market, World Gym and Cary Ann Hallmark. The building totals approximately 94,000 square feet.

WHO: NorthPoint Capital – Michigan Inc. arranged financing through ING Investment Management, a NorthPoint Capital correspondent life insurance company.

$$$: $3.1 million.

TERMS: The fixed-rate loan carries a term of 10 years with a 30 year amortization period.

NorthPoint Capial – Michigan: (248) 553-5500.


WHAT: This office-warehouse facility has undergone extensive renovation in the past two years. It contains approximately 62,000 net rentable square feet – 10,000 square feet of which is office space. There are five truck docks on the southwest corner of the warehouse portion of the structure, and parking is provided for 47 automobiles on the 2.6-acre land parcel. The sole tenant of the property is Lake Cable LLC, a wire and cable business.

WHO: Chicago-based Dwinn-Shaffer & Co. negotiated the financing for this property.

$$$: $2.25 million.

TERMS: A nonrecourse first mortgage loan was arranged at a fully amortized fixed rate for 30 years.

Dwinn-Shaffer & Co.: (312) 346-9191.


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