Higher Interest Rates Spell Good News for Acquisitive Pension Funds, Says Researcher

Though borrowers may frown on rising interest rates, they are a welcome sight for institutional real estate investors bent on gobbling up properties over the next 12 months, according to Morgan Stanley’s U.S. Real Estate Investing Division.

Kevin Midwinter, director of real estate research at New York-based Morgan Stanley, writes this week that “higher borrowing costs will enable institutions to more effectively compete for acquisition opportunities.” Specifically, Midwinter emphasizes that the weighted average cost of capital advantage currently enjoyed by many buyers utilizing significant amounts of low-cost debt to fund acquisitions is expected to diminish over the coming year.

The researcher’s remarks come as the 10-year Treasury yield, the benchmark for permanent fixed-rate financing in commercial real estate, has surpassed the 4.50% mark after dipping as low as 3.92% in February. For much of 2004, the 10-year yield hovered near 4%, which enabled private buyers to leverage up their balance sheets. But now most economists predict the 10-year yield will likely approach 5% by year’s end.

Morgan Stanley is slightly more bullish about interest rates, predicting the 10-year yield will end the year at 5.25%, which would mark a 110-basis point increase for the year. The 90-day LIBOR also is expected to rise 136 basis points in 2005 to finish the year at 4.18%, Morgan Stanley forecasts.

Since institutions tend to use debt more conservatively than private buyers, the result has been a higher cost of capital that has put institutions at a competitive disadvantage, Midwinter writes. Sales transaction figures support Midwinter’s conclusions about the dominance of private buyers. Real Capital Analytics reports that private buyers have acquired 50% of all office, multifamily and retail properties sold in the past few years.

The net effect has been that private buyers have established market pricing and won a disproportionate share of acquisitions, generally at the expense of institutional investors and public REITs, which typically employ much lower debt levels, according to Midwinter. But the tables are turning. “Gone are the advantages of using high levels of fixed- or floating-rate debt to achieve very low weighted average capital costs,” the researcher writes.

Still, Midwinter doesn’t expect a rise in interest rates to have a dramatic effect on cap rates — the return based on the purchase price — anytime soon. That’s because there is still sufficiently strong capital flows coming into real estate. “We do not recommend institutions wait on the sidelines for a potential future correction in values,” concludes Midwinter. “We view a rising interest-rate environment as a positive competitive development for institutions targeting real estate investment opportunities and urge clients to renew their acquisition activities.”

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