The Problem of Low Interest Rates

With the U.S. Treasury 10-year bond interest rate around 4% and shorter-term rates even lower, most real estate practitioners are rejoicing. But low rates also are causing some problems in commercial property markets.

The first problem is apartment overbuilding. According to the Department of Commerce, the rental vacancy rate hit 9.4% in the first quarter of 2003 — the highest in the past 20 years. New starts of structures with five or more units remained at an annual rate of over 300,000 units — greater than all but two years since 1990. Investors' insatiable appetite for rental apartments leads them to buy at cap rates as low as 5.5% to 6.5%.

Lenders also loaded with capital are anxious to lend to developers. When developers can borrow at record low rates, and sell new properties quickly at record high prices, many build and sell out fast.

A second problem is overpaying for existing commercial properties. This is fueling the disconnect between deteriorating space-market conditions and rising prices for well-occupied properties. Office and industrial rents have fallen sharply and vacancies have risen in the past year — though conditions are now stabilizing.

Yet investors looking for higher yields than bonds are bidding strongly for office and industrial properties that have high occupancy levels and leases not turning over for three to five years. Hence such properties are selling for rising prices, partly because buyers know they can leverage their equity at extremely favorable rates.

An Advantage for Unlisted REITs?

This over-bidding for properties is further encouraged by the explosive growth of unlisted real estate investment trusts. These REITs are being sold by financial advisors and stock brokers mainly to retail buyers who want to own real estate to avoid the stock market's volatility and uncertainty. Unlisted REITs are not publicly traded, so their shares are not visibly valued every day.

Promoters claim this is a great advantage because there is little visible volatility in the prices of these securities, compared with publicly traded REITs. Unlisted REITs promise their buyers fixed dividends of 6% to 8% per year. But the liquidity of these investments is clearly less than that of publicly traded REIT shares. Yet the four big creators of these investment vehicles sold $4 billion in shares in 2002, and may sell from $6 to $8 billion this year.

What many buyers of unlisted REIT shares may not realize is that 15% to 20% of the money they invest is paid upfront in sales commissions and fees. That leaves only 80% to 85% available to actually invest in properties.

For the REITs to pay the 6% to 8% dividend on the full amount invested, the REITs must heavily leverage the investors' funds by borrowing at current low rates. Then they are able to bid up prices of desirable properties to cap rates of 5.5% to 7%. For example, Wells Real Estate Funds — the largest of these unlisted REITs — spent $1.4 billion on Class-A office buildings in 2002. That made it the largest buyer of such properties in the nation.

Price Inflation Problems

Low interest rates plus leveraging are what permit instruments with high front-end fees to outbid other potential property buyers. Their financial structure enables them to dominate property markets, just as the structure of publicly listed REITs similarly dominated those markets in 1996 and 1997. Why can't publicly listed REITs raise similarly large amounts?

The main reason is that unlisted REITs are being aggressively sold to investors by financial advisors and brokers motivated by high front-end commissions that publicly listed REITs do not — and cannot — pay. This confirms the old principle that “stocks are rarely bought, they are sold by someone motivated to promote them.” Also, publicly listed REITs must reveal their borrowing, and are pressured to stay below about 60% debt.

In my view, buying shares in unlisted REITs is inferior to buying listed REIT shares directly. Publicly traded REITs do not take 15% to 20% off the top for commissions, must meet market valuation tests daily, and have complete liquidity — while still paying dividends between 5% and 8%. But right now, the flood of money into unlisted REITs, which must invest that money immediately, no matter how much they have to pay for properties, is a major factor inflating the prices of well-occupied properties to levels that are becoming questionable.

Anthony Downs is a senior fellow at the Brookings Institution in Washington, D.C. He can be reached at [email protected].

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