It seems like every time you pick up a newspaper or business magazine these days, someone is writing about how the much-anticipated rise in interest rates is going to burst the current real estate â€œbubbleâ€ and wreak havoc on the sector. And while itâ€™s true that prices are high in many geographic areas, the concerns are mainly focused on the rising prices of residential real estate.
In residential real estate, higher interest rates mean buyers need more money to purchase a home. Consequently, the number of possible buyers decreases and so does demand.
But what do interest rate hikes mean for commercial real estate investors?
There are some who believe rising interest rates will cause the bottom to fall out of commercial real estate and compare it to the dot-com boom and crash of the late 1990s. I disagree. In fact, an increase in interest rates now may be the absolute best thing that could happen to the real estate sector, and a real boon for smart, patient investors.
It has been a long time since the real estate sector has seen so much demand for such limited product. Iâ€™ve been in the real estate investment business for a quarter century and Iâ€™ve never seen this much capital chasing deals. The market is overcapitalized, even if few people want to say so. Prices are soaring. Lackluster properties are looking strangely attractive to investors who ordinarily would never give the property a second look.
With real estate offering some of the best returns of any asset class over the last two years, the market has seen an explosion of new players â€” sponsors who are recommending products to financial advisors, including former stock market hounds new to the sector looking for an alternative to underperforming stocks and poor bond yields. There are dozens of new real estate funds, real estate investment sponsors, and real estate offerings in the marketplace, paying a low rate of return â€” or worse.
As an example of the boom in commercial real estate investment activity, tenant-in-common (TIC) investment properties had four or five sponsors in 1996. Today, there are about 75. That kind of growth should be a red flag to investors looking for experienced TIC sponsors. It should be a reminder to check the track record of any sponsor youâ€™re considering as an investment partner. And ask questions. For example, do your sponsors have their own money in an acquisition or fund? Itâ€™s a good sign if they do.
In this kind of bustling environment, everyone is under tremendous pressure to find good investments and maintain high yields. A few years ago, you would be bidding against three or four others for a quality property with an attractive yield; today you may be bidding against 15 to 20 other buyers. Broker dealers, sponsors, pension fund managers, financial planners, and high-net worth investors all are looking for the next big deal.
The largest real estate funds are under the most pressure, since they have the most money to invest â€” even if there is a shortage of quality products in the market. Itâ€™s hard to sit on $100 million when your investors are counting on you for returns. But smaller funds with less capital to deploy find it easier to maintain investment discipline. Smaller funds are more nimble and can search for secondary or off-market deals that donâ€™t require an enormous amount of capital. Smaller funds also are under less pressure to invest, and are more willing to spend the time it takes to find high-quality investments. There are still good investments to be made, it just takes more time and work to find them. And when a good investment cannot be found, a smaller fund has the flexibility to sit on the sidelines for a short while until things cool down.
In commercial real estate investing, the real impact of rising interest rates cannot be understood without also looking at job growth â€” a true indicator of real economic growth. In commercial real estate, economic growth means lower vacancy rates, greater cash flows for investors and an increased demand for properties in the short run.
If interest rates increase faster than job growth, weâ€™ll see a dip in cash flow and the demand for properties will decrease. If rate hikes are slower than the rate of job growth, weâ€™ll continue to see an overcapitalized market where third-rate properties command first-rate prices. In this environment, it is easy to loose sight of real value. Ultimately, as the market stabilizes, some investors could get hurt.
So the best scenario for commercial real estate investors is rate hikes that mirror the rate of real economic growth. This would help stabilize parts of the industry that currently are overcapitalized and bring investors closer to seeing the real value of their investments.
Meanwhile, our guidance to investors â€” and those who advise them â€” is to stick to your guns and keep three important things in mind:
Remain true to the fundamentals. Real estate can still be a good investment, if you stick to the fundamentals. If thereâ€™s a big gap between what a property will pay and what investors expect, youâ€™re in a danger zone. For example, we were investing in corporate headquarters properties when the yield was a 9 â€“ 10 cap. When investors started pouring in, property values rose and the cap dropped to 7, we didnâ€™t like the risk profile on the return and stopped investing. The numbers either run or they donâ€™t. Donâ€™t stretch. This is not a business where you want to count on getting lucky.
Stash your cash. Donâ€™t invest money just because you can raise it. Thatâ€™s bad business. Investors should hold their cash until they find the right deal. Take your time.
Work with a trustworthy and transparent sponsor with a proven track record of success. Small to mid-size sponsors are under less pressure than huge funds to place money. Look for a sponsor that conscientiously manages the â€œcash inventoryâ€ and is smart and nimble enough to identify a new niche before everyone else jumps in. Smart sponsors will opt for better deals and more creative solutions, even if it means they have to do less investment in the short term.
These days, nimble, creative real estate sponsors are looking for opportunities in secondary markets and second-tier cities. They are seeking out regions with active economic development projects to attract properties like corporate headquarters and manufacturing plants. They are looking at a range of deal structures, including joint ventures with real estate developers. And theyâ€™re looking for recovering sectors with hot niches ready for growth, such as luxury hospitality properties.
It is likely that the Federal Reserve will continue to raise interest rates. How you manage the current market will make all the difference in how your portfolio emerges. By focusing on the fundamentals, maintaining a disciplined allocation strategy, managing your capital and working with the right sponsor, your portfolio will be positioned to flourish in an environment of rising interest rates.