U.S. MarketFlash | Post-election interest rate rise modestly impacts commercial real estate pricing
U.S. MarketFlash | Post-election interest rate rise modestly impacts commercial real estate pricing
January 19, 2017
Interest rates have increased significantly since the Nov. 8 presidential election, including an initial spike of as much as 70 basis points (bps) in the benchmark 10-year Treasury yield. As of Jan. 18, this spike had moderated to approximately 50 bps. Interest rate volatility, combined with the increased uncertainty about its overall direction, will be a significant factor in commercial real estate pricing in 2017. How has it impacted pricing to date?
To reach a conclusion, we examined 189 transactions with more than $10 billion of aggregate value that have either closed or are in negotiation since the election. Of these 189 transactions, we focused most closely on the 116 of them that have either closed or have a non-refundable deposit and are proceeding to closing. Our study reached the following conclusions based on these 116 transactions:
70% proceeded without any change in price.
Of the deals that closed, 63% did not receive any price adjustment
Of the deals in process with non-refundable deposits, 75% are proceeding without a re-trade
The price adjustments ranged from 0.4% to 11.0%.
The average price adjustment granted was approximately 3.0%.
While we have seen greater movement in some asset types than others, our sample size is limited, particularly when looking at specific asset types or subtypes. Therefore, the price movement ranges cited above may not be applicable to all asset classes.
In addition to recording transaction data, CBRE conducts a biannual cap rate survey among our top professionals. While our new survey results have not yet been published, our data is in and provides a snapshot of where our professionals believe cap rates have moved across the major asset types and markets since the election.
Pricing pushback from buyers remains strong and we are likely to see buyers press for further price reductions. As we are late in the cycle and fundamentals have weakened in several asset types, we cannot fully separate the interest rate pricing impact from cyclical factors.
The pricing reaction for closed transactions to-date is similar to but slightly higher than the pricing impact of the so-called “Taper Tantrum” of 2013 when the Fed began reducing quantitative easing (QE) stimulus and a selloff in the bond market ensued, causing a spike in interest rates. What are some of the differences between 2013 and today?
Timing of the rise: The interest rate spike of 2013 occurred roughly at midyear. This arguably gave more bargaining leverage to sellers, who had the luxury of waiting out changes in market conditions. By contrast, the spike of 2016 occurred very late in the year and most institutional managers were under pressure to get money out, providing limited leverage to negotiate a re-trade. If this was a factor, it gives credence to our observation that additional price reductions may be in the offing as negotiating leverage shifts slightly from sellers to buyers.
Cost of capital vs. increased optimism: The current interest rate spike has been catalyzed by the perception that the Trump administration will team up with the Republican-controlled Congress to pass a pro-business agenda. If this pro-growth agenda becomes reality, it could improve economic fundamentals generally (increased GDP, employment and consumption growth) and specifically for commercial real estate (increased rent growth as occupier optimism leads to business growth). As such, a greater price decrease may have been mitigated by somewhat stronger rent growth assumptions by buyers.
Some interest rate increases already priced in: Many buyers explicitly priced in a 20-to-40 bps increase in interest rates. As the market moved well above that level, re-trade activity accelerated. A study by CBRE Global Chief Economist Richard Barkham concludes that for every 100-bps movement in interest rates there is a corresponding 70-bps adjustment in cap rates. This price change may take up to 18 months to be fully reflected. However, this effect may be significantly smaller if economic growth expectations remain strong. Dr. Barkham notes that the impact of rising rates can be offset for at least a year by strengthening fundamentals, but that over the long term bond rates will trump short-term fundamental improvements.
We also asked a number of CBRE transactional professionals for information on what they are seeing in the field between buyers and sellers. Their observations run the gamut: from sellers reducing prices by more than $1 million, to their not granting any price concessions at all. In between have been all manner of changes, from smaller re-trade amounts to changing the terms of financing. A few representative notes we received from our professionals are as follows:
“Buyer requested a $1.5mm price reduction while hard on $1mm. Buyer had waived due diligence without rate locking. No price reduction provided. Deal closed with no re-trade.”
“Price reduction was requested, and was not granted by seller.”
“The property was under contract, but not firm prior to 11/8/2016. The buyer did not request a price reduction due to the rise in interest rates.”
“Deep-value-add mitigated the re-trade.”
“Requested $450,000, granted $150,000.”
“Buyer built in a 25-bps cushion for interest rate movement, with movement exceeding 25 bps they re-traded to account for approximate loss in value.”
“The buyer had 30 bps budgeted for interest movement, we missed that by 40 bps.”
Changed Financing Terms
“Buyer switched from 10-year fixed rate debt to seven-year fixed rate.”
“Buyer switched to floating rate debt.”
Non-Interest Rate Re-trade
“60% of re-trade was physical and tenant issues, 40% was cost of capital increase and CMBS uncertainty.”
“Also impacted by leasing softness—not all re-trade dollars attributed to debt.”
“Buyer decided to drop deal without a re-trade.”
“While we were picking the buyer, top four groups pulled offers.”
“Seller refused re-trade (one week before go-hard); deal is dead.”
“Buyer's equity dropped out due to interest rates. Deal pulled from market.”
In addition to individual trades, we are tracking several other indicators of value and market conditions. They are as follows:
Debt market conditions: Commercial real estate capital markets remain deep and liquid across most asset types, but we have seen different market reactions from different lender types. Life insurance companies are the least impacted by rising rates, in large part due to their relatively low loan-to-value (LTV) requirements compared with other lender types. Most life company floor rates have disappeared, and they’re much more willing to lend in a higher interest rate environment and at this time of year with fresh allocations of capital. Some life companies have lowered spreads by 5-to-10 bps, but until competitive pressures return in abundance most will likely hold spreads constant. Bank rates and spreads have not been materially impacted by the rising 10-year Treasury either, due to the LIBOR-based lending that is typical of banks. Construction loans remain very difficult to obtain, and likely will be for the foreseeable future. The most-impacted by rising rates are the full LTV lenders: agency (Freddie Mac and Fannie Mae) and CMBS lenders. For full agency loans, we have seen proceeds cut by up to 5% due to debt-service coverage constraints. Non-bank financial institutions have been able to fill some of this funding gap, albeit at higher cost.
A summary of where rates generally stand today:
Life company spreads range from 140-to-170 bps over the comparable 5-, 7- or 10-year Treasury, resulting in absolute rates of 3.30% to 4.25% depending on LTV.
Freddie/Fannie spreads range from 150-to-180 bps on a fixed-rate basis for low leverage loans, and 190-to-240 bps for higher-leverage loans up to 80%. For floating rates, spreads over LIBOR range from 200-to-220 bps for low leverage and 220-to-250 bps for higher leverage up to 75%.
Bank lending spreads range from LIBOR + 175-to-300 bps (average LIBOR 200-to-225 bps; debt yield of 8.5% to 9.5%).
Mezzanine lenders interest rates range from 7% to 12%, with 8% to 10% being the most common (all-in).
Net lease: As with the broader investments noted above, the range of re-trade on net-lease properties varied deal-to-deal, but in several instances there was no re-trade (deal closed at contracted value). In deals that had a re-trade, it ranged from a 10-to-30-bps increase in the cap rate.
Appraised value: Since the election, CBRE’s Valuation and Advisory Services Group has performed more than 8,500 appraisals. Class A multifamily is the only property type where appraisers would likely be unified in raising cap rates perhaps 25 bps with no movement on Class B and C multifamily assets. Despite this consensus, Class A multifamily space is in a state of flux with significant ongoing re-trade discussions between buyers and sellers. We don’t see a market consensus in any other property type as yet. We have seen a notable uptick in appraisals on behalf of non-bank financial institutions, which corroborates what we are seeing from our debt and structured-finance professionals in the field. Another forward indicator is in the sentiment of our clients, for whom we perform quarterly asset values. The concerns expressed by institutions are toward the downside, questioning if cap rates are a bit high and rent growth assumptions a bit aggressive in order to minimize any changes in value they show to their clients.
In conclusion, the market has shown only limited price movement since the post-election interest rate spike. Given where we are in the cycle, it is difficult to determine whether those transactions that re-priced did so because of the change in the cost of capital or because of fundamental cyclical concerns. Monitoring fundamental indicators (rent growth, vacancy) will be at least as important in 2017 as will the trajectory of cap rate movement. Most market participants believe the Fed will be true to its word and raise short-term rates three or four times (75 bps to 100 bps total) in 2017. The CBRE Econometric Advisors model suggests a year-end 10-year Treasury rate of approximately 3%. Keep in mind that investors have consistently been wrong about the Fed’s intentions for the past few years. Furthermore, the Fed’s rate increases will only directly impact the short-end of the curve. Long-term rates are impacted by global events over which the Fed has limited control.
CBRE will continue to monitor price movements and report our findings as circumstances warrant. In the meantime, we are keenly focused on the policies of the incoming Trump administration, in particular potential tax changes that will impact the commercial real estate industry. We will publish another report and conduct a conference call on this topic as policy choices become clearer.