Saturday, September 22, 2007

Commercial CAP Rates on the Rise

For all of the talk that Commercial Brokers spoke about bifurcated markets (residential on the decline and commercial strong and steady), there is evidence that commercial pricing among all assets classes is starting to drop. Institutional investors aren't staying away because of the "credit crunch", they are staying away because they fear prices will drop another 10-15% by year end (echoing what Sam Zell was discussing in the last post about a "confidence crunch" vs. a "credit crunch").

A recent article from RetailTraffic reiterates these sentiments from the 4Q of 2007 with rising CAP rates on all commercial asset classes due to the tightened credit and underwriting guidelines for commercial deals. This translates to lower pricing models and higher CAP rates moving forward:

In July, investors closed the smallest number of commercial real estate deals since August 2006, at 930 transactions valued at more than $5 million, Real Capital Analytics researchers told

Stephannie Mower, executive vice president with PM Realty Group, a Houston-based real estate services firm, reports that this July the firm experienced a 14 percent drop in sales activity across all asset classes, the worst performance in five years.

She says many of her institutional clients are purposefully staying away from acquisitions right now, not because they don't have the cash, but because they figure that prices will soon begin to drop on even the best quality assets. Across the board, they expect to see a discount of 15 percent before year's end.

Troubles in the debt markets are crippling leveraged buyers. Conduit lenders especially have stumbled, unable to sell loans they originated at terms they used six months ago into a secondary market suddenly squeamish about risk. From 2006 to August 2007, spreads to 10-year Treasuries on AA-rated fixed-rate CMBS loans, for example, more than doubled, jumping 122 basis points in all to 211 basis points from 89 basis points in 2006, according to RBS Greenwich Capital. Meanwhile, spreads on A-rated loans rose 162 basis points, to 261 basis points, and spreads on BBB-rated loans rose 262 basis points, to 396 basis points.

Bernard J. Haddigan, senior vice president and managing director of the national retail group with brokerage firm Marcus & Millichap Real Estate Investment Services says CMBS lenders also no longer play fast and loose with their underwriting. They won't grant investors interest only mortgages, nor are they willing to hike up the loan amount to cover for small property defects, such as a vacant space, in a core asset. In the past year, the acceptable loan to value ratio dropped to 60 percent, whereas in 2006, investors still closed deals at 95 percent loan to value.

"Now the lenders are really looking at their coverage," Haddigan says.

With all the troubles in the debt market, however, investors are demanding higher returns, Farahnik says. So if last year an acceptable ROI for a given deal was in the mid-teens, this year, that number moved to the high teens.

That kind of attitude drives the market right now, according to French. Though buyers are putting out lower bids on class A assets--this summer, some offered bids of 8 percent and higher--and though the period between the listing and the closing nearly doubled to 150 days compared to 2006, people still think that retail properties are a good investment.

Going forward, however, that equilibrium might not last. In the past few years, the private investors and 1031 exchange buyers drove cap rates down by taking on a lot of leverage, according to Mower. Now that the credit crunch has limited their ability to borrow, institutional funds will once again rule the day.

For additional information on swap spreads go to this article from Kenny Pratt @ SimpleRE for some great insight.

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