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Seasoned and novice commercial real estate investors alike have hit pay dirt in recent years. Rapid price appreciation of assets across all property types has resulted in huge returns in a short period of time for owners — often with minimal effort on their part. But the days of the easy money are likely numbered, say industry veterans.

Over the past two years, commercial real estate investors have repeatedly demonstrated a willingness to buy assets despite soaring prices, resulting in correspondingly lower yields or capitalization rates. The average cap rate for multi-tenant office properties, for example, plummeted from 8.5% in the first quarter of 2004 to 7.1% in the first quarter this year, according to Real Capital Analytics, which tracks deals $5 million and higher.

But the incredibly low cost of capital that fueled that pricing spiral is on its way up as both short-term and long-term interest rates rise. The 10-year Treasury yield, a benchmark for long-term permanent financing, registered 5.22% on June 23 — a four-year high. The rising cost of capital has already halted cap-rate compression in most asset sectors. Industrial caps climbed slightly to 7.25% in April, while those for retail properties edged upward to about 7%.

What's more, the Federal Reserve was expected to boost the fed funds rate a quarter point to 5.25% in late June. With core inflation — which excludes volatile energy and food costs — rising at an annualized rate of 3.2% in recent months, the Fed may well bump up the short-term rate again this fall, potentially driving long-term rates even higher.

The challenge for smart investors is to compensate for the lost benefit of cap-rate compression, which for two years has driven price appreciation and accounted for at least half of returns, says Craig Thomas, senior vice president and director of research at Boston-based Torto Wheaton Research.

“Managers will have to replace that 50% of return with something else, and they're doing it by moving farther out on the risk spectrum,” Thomas says. “They're buying value-added properties. They're trying to reposition properties. Those are ways to make up for a cap rate that's not moving, but it is risky.”

The way we were

Any slowdown in price appreciation would come as a shock to newbie investors attracted to commercial real estate by the prospect of achieving huge returns almost overnight. Their confidence has been bolstered by a tremendous amount of deal volume in the marketplace benefiting sellers.

In June, Six Times Square, a Class-A office building in Manhattan, sold for $300 million, nearly double the $156.1 million the seller paid to acquire the asset just 19 months before, reports Real Capital Analytics. The dramatic run-up in prices has occurred nationwide, particularly for the most desirable assets.

In January, Orix Real Estate Capital realized a 59% gross profit when it sold One Alltel Center in Atlanta for $37 million, after holding the 530,000 sq. ft. office building for only seven months. In Los Angeles this past May, Arden Realty Trust made a 72% gross profit with the $160 million sale of 5670 Wilshire Boulevard after a 13-month hold.

Investors will have a hard time achieving similar results in the future, Thomas predicts. “I'm seeing people just buy properties at a low cap rate and expect 11% rent growth for the next five years,” he says. “We just don't think that [growth expectation] is reasonable in most markets.”

Sweat equity

Like the mythological Sisyphus, tirelessly pushing a boulder uphill, many investors have resigned themselves to cultivating cash flow without relying on market-wide appreciation. Advance Realty Group in Bedminster, N.J., for example, has found a lucrative niche in acquiring raw land, shepherding it through local permitting processes and then selling the land to developers.

Since the beginning of 2005, the company has obtained development approvals for three parcels and sold them to major residential developers at an average return of 200% over its own costs, according to Gary J. Sopko, Advance Realty's managing director of acquisitions. “It's a tremendous profitability center for us,” he says.

Chicago-based Equis Corp., a global tenant representation firm, is helping government agencies, universities and other institutions identify and liquidate parking garages, sports arenas and other real estate assets. In the process, Equis is introducing unique investment opportunities to the market. Examples have included sale-leasebacks of office buildings and outright sales of dormitories, fairgrounds, power generation plants and other non-traditional assets to private operators and investors.

“The investor in a government- or university-occupied asset has the dual benefit of a bond-like return from a government institution, and the real estate, which has a future value with or without the institution,” says Michael Silver, president of Equis.

The vacancy gamble

“The big strategy today is to create income streams, not buy them,” says Josh Scoville, director of strategic research at Boston-based Property & Portfolio Research. The most common approach to growing net operating income is to buy poorly occupied or vacant properties and attempt to fill the space with tenants.

The market is primed for that sort of rental growth, Scoville says, because 10-year leases that will require renewal in 2007 and 2008 were signed at the bottom of the 1990s real estate cycle. That means landlords can expect to increase income from those spaces simply by raising rent on new leases to current market levels.

Ironically, investor demand for vacant properties has driven up prices to the same level as core assets, which have stabilized tenancy and require few improvements (see chart on p. 28). Value-added acquisitions account for nearly one-third of recent office transactions, according to Bob White, president of Real Capital Analytics.

“It's a marked difference from 2003, when everybody wanted long-term, single-tenant leased buildings and didn't want any exposure to the leasing market,” White says. “Now people want some vacancy and some rollover, and the ability to realize increasing rents they think are going to occur.”

Finding a new audience

Repositioning a property to appeal to a higher-paying set of tenants or buyers can increase value in a relatively short time, says Anthony McElroy, managing director of acquisitions at Colliers ABR in New York, a full-service real estate firm.

A variation on repositioning is the conversion of a space for sale as commercial condominiums, of which medical office condos are probably the hottest sector this year, says James Haft, CFO of U.S. Condo Exchange, which facilitates the rental and sale of condominiums through its Web site, Some developers are able to reduce their risk in a condo conversion by pre-selling units to end users before construction, Haft says.

What sage investors aren't doing is sticking to the passive, buy-hold-sell strategy, which is losing its effectiveness without further cap-rate compression, according to Stuart Gross, executive managing director at New York real estate investment services firm Eastern Consolidated.

“The easy money was where you could have positive leverage on acquisitions, apply your equity, and just buy and hold for 18 months [then sell for a profit],” Gross says. “That sort of dumb luck is over, because interest rates have pretty much gone upside down on cap rates.”

Caps hit bottom

Cap-rate compression is largely grinding to a halt in all but the office sector, according to Hessam Nadji, managing director of research services at Marcus & Millichap. Cap rates have risen for apartments and single-tenant office and industrial properties, although they continue to compress for multi-tenant office and industrial assets, which have better prospects for bumping up rental rates.

“Across all major commercial real estate property types there is a bifurcation in the market, where cap rates for lower-quality properties have bottomed and have risen by 25 to 50 basis points,” Nadji says. That doesn't mean there will be a major upward correction in cap rates, however. “Demand is still very deep for real estate, both private and institutional; fundamentals are improving and interest rates remain relatively low.”

Interestingly, cap rates are stable for multi-tenant retail. Retail sales growth is projected at 6% this year, down from 9% in 2005 but still positive, Nadji says. The sector is enjoying strong rent growth, and that promise of increased rental income down the road helps to offset the influence of rising interest rates on cap rates.

Rising interest rates also increase the appeal of less-risky alternative investments such as bonds, which reduces the demand for real estate and helps deflate the high asset prices that accompany low cap rates. Bond yields don't have to rise to a level that matches real estate returns in order to draw away investors either, according to Edward Indvik, president of Industry, Calif.-based real estate firm Lee & Associates Industry.

If bond yields simply narrow the gap to real estate returns, investors will be drawn to the liquidity and lower risk available in the bond markets. “You can sell your bond with a phone call,” Indvik says. “If you're lucky, you can sell your real estate with 90 or 120 days of marketing.”

Dilemma for passive investors

If the economy — and a titanic single-family residential industry in particular — fail to slow down sufficiently to reduce inflation, the Fed may extend its series of rate hikes into recession-triggering territory. Even a brief recession would halt spending, real estate absorption and rental rate increases, adding to the investor's uphill struggle to achieve higher annual returns.

“The unraveling housing boom could put us right into recession, in which case there is no rent growth. That affects office, retail and industrial,” says Thomas of Torto Wheaton. “We don't think that is going to happen, but the risk is very real.”

How should investors adapt? Start by adopting reasonable expectations for returns that reflect a property's existing cash flow. Projections for boosting returns should be based on specific improvements, according to Doug Wilson, founder and CEO of Douglas Wilson Cos. The San Diego-based development and business-workout company specializes in problem resolution.

“Investors have got to get back to the old rules of thumb, which is having well-capitalized, well-located projects without overly aggressive assumptions regarding increased values,” Wilson says.

A soft landing?

Market watchers say investors may be more comfortable with the elevated risk of value-added, or opportunistic, deals today because there are potential buyers waiting to pounce on properties that become distressed. Indeed, Thomas says some of his clients are on the lookout for buying opportunities as climbing interest rates crank up the pressure on overleveraged owners.

For investors who find themselves struggling to maintain debt service on their properties, those buyers may provide a welcome exit strategy that wasn't available in the real estate crash of the early 1990s, when the market sorely lacked liquidity for bailouts. Today's investors may well take a loss in a resale, Thomas says, “but nobody's going to be giving the keys back to the bank.”

Matt Hudgins is based in Austin.


NREI asked six economists to predict the near-term direction of key indices. Here are their responses:

Dr. Rajeev Dhawan: Director, Economic Forecasting, Georgia State University Prediction: “The Fed will do a rate cut by late spring 2007 in response to well-behaved inflation and below-trend output growth. See, there eventually is good news for financial institutions!”

Hessam Nadji: Managing Director of Research Services, Marcus & Millichap Prediction: “Economic uncertainty will persist as the housing market slows and indicators remain mixed, [so] investors are likely to lean toward the relative safety of Treasuries and improving real estate sectors/markets. That is why, despite inflation pressures building, long-term rates are not likely to rise much.”

James Smith: Director, Business Forecasting, University of North Carolina Prediction: “Great progress toward peace and democracy in Iraq, a boom in U.S. exports, and the Republicans make gains in both houses of Congress in November. The commercial real estate market should stay very strong well into 2007.”

Diane Swonk: Chief Economist, Mesirow Financial Prediction: “If we actually see a regime change in Iran that would be more internal than external, that could have a very dramatic positive effect on bringing down oil prices.”

Craig Thomas: Senior Vice President, Torto Wheaton Research Prediction: “The inflation genie will be out of the bottle. Fewer commercial real estate transactions will have us worrying about asset prices, and the most optimistic rent expectations will begin to reveal themselves as overly aggressive. Fortunately, the expansion will continue, but at a slower pace.”

Jamie Woodwell: Senior Director, Commercial Research, Mortgage Bankers Association Prediction: “I expect sub-par economic growth as a result of slowing consumption growth.”

GDP (%)
Job Creation
Treasury Yield (%)
($ per Barrel)
Dhawan 3.2 1.9 5.4 $66
Nadji 3.4 2.2 5.0 $70
Smith 3.8 2.0 4.48 $31.75
Swonk 3.4 1.5 5.3 $65
Thomas 3.3 2.3 5.3 $60
Woodwell 2.9 2.1 5.2 $69
*GDP figures reflect total economic growth for 2006

Will the Fed go too far?

Several industry watchers warn that the Fed's inflation-fighting reins on the economy could choke off promising economic growth. The Fed was expected to raise the short-term fed funds rate, which banks charge for overnight borrowing, 25 basis points to 5.25% at its meeting in late June.

That would flatten the yield curve by raising short-term rates to be on a par with the 10-year Treasury yield, which reached a four-year high of 5.22% on June 23. The Fed may then move to the sidelines.

But with core inflation — which excludes food and energy prices — growing at an annualized rate of 3.1% in the first five months of 2006 compared with 2.2% in 2005, the Fed may raise rates again in the fall, says Diane Swonk, chief economist at Mesirow Financial. Such a move would help new Fed Chairman Ben Bernanke appear tough on inflation. “To be a tough guy on the street, you only have to beat up one person,” Swonk says. “This is going to be his one person.”

With short-term interest rates likely to surpass the yield on long-term bonds after the Fed's meeting this fall, some economists anticipate a brief economic recession. Plenty of economic theories attempt to explain the relationship between recessions and inverted, or “negative,” yield curves, in which short-term interest rates exceed long-term rates.

It may be that rising short-term interest rates choke economic activity, which would make the inverted curve a symptom of the Fed's hikes rather than a recession trigger. Most inverted yield curves in the past half-century have immediately preceded a recession.

One economist on the recession watch is James Smith, director of business forecasting at the University of North Carolina. Smith, recognized as one of the nation's most accurate forecasters, projects a recession in 2007 will be ended quickly by falling short-term interest rates, “with 2008 being a very good year.”
— Matt Hudgins

Shrinking workforce to slow office demand

Slow job growth constrained by a tight labor market will limit demand for office space this year and may become a major problem in the next decade, researchers say. That's bad news for investors who hoped double-digit rental growth would replace shrinking cap rates to drive increasing returns.

Nationwide, office vacancy fell in the first quarter to 14.3% from 16.4% a year earlier, and rents are beginning to rise, according to Grubb & Ellis. But the slowing economy generated a paltry 75,000 jobs in May, the third straight month of decline and the poorest monthly performance since Hurricane Katrina nearly halted hiring last fall.

The May unemployment rate of 4.6% is essentially full employment, so even when the economy accelerates, a finite labor force may constrain job creation to incremental growth, with correspondingly slow increases in space demand, researchers say.

The workforce is beginning to shrink as the oldest Baby Boomers retire and fewer new workers take their place, says Josh Scoville, director of strategic research at Property & Portfolio Research. The boomers make up nearly 27% of the U.S. population, according to Census data. “It's going to continue to be an issue through 2020 or 2021, which is when the labor-force growth rate starts to accelerate again,” Scoville says.

The U.S. economy will create about 1.91 million jobs by the end of this year, down from 2.05 million in 2005, predicts Dr. Rajeev Dhawan, an economist with Georgia State University. Slower employment growth is expected to continue, with 1.75 million new jobs in 2007 and 1.69 million in 2008, as the economy adjusts to a slower growth rate, Dhawan says.

One real estate researcher finds comfort in the large percentage of new jobs that will require office space. Many health-care, financial, and other service-industry jobs are being created to serve the aging population, says Robert Bach, head of research at Grubb & Ellis. “Even if we only create 1.5 million jobs next year, 400,000 of those will probably be in the office sector.”

The key for investors may be realistic expectations. Bach expects unspectacular — but healthy — absorption and rent growth for at least two more years. “If the economy continues to grow, there will be demand for office space and we will see absorption.”
— Matt Hudgins

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