Uncertainty – The Only Certainty
July 31, 2022
Nick Miner, CCIM
Office: (480) 612-0384
Cell: (480) 226-8037
When canvassing the commercial real estate market in Phoenix, there are so many positive indicators that it is hard to imagine a slowdown. Every time you read the news or look at the business journal, there is a new company calling Arizona home and specifically here in the Valley.
GPEC and ACA are doing a phenomenal job in recruiting businesses to our community. This massive amount of diversity added to our economy seems unstoppable since the financial downturn of 2008-2010. This has pushed Phoenix to one of the top growing cities in the country and the continued expansion of international, national, regional, and local companies should continue for the foreseeable future.
A lot of my clients have been contacting me about recent macroeconomic events, specifically the change in interest rates, and how that is going to impact commercial real estate values. As we start the discussion, I always like to remind my clients of a few key points before we really start getting into the numbers. First, commercial real estate has always been a lagging indicator; employment drives the demand for the need for commercial space. Secondly, short term rate changes do not necessarily mean an immediate change in financing for their commercial properties. Commercial real estate is typically tied to the 10-year Treasuries, which is currently around 3.2%, which is up about 1.5% since January of this year. Lastly, commercial real estate is typically a long-term investment.
After we have that baseline discussion, we then talk about current market capitalization rates (cap rates). The cap rate is the unleveraged return for the first year of ownership that an investor can anticipate given the price they would pay (to calculate this, I always tell everyone to remember Uncle IRV – NOI (full year net income) divided by Rate of Return (cap rate) = Value (Sales Price)). There are several factors that need to be considered when looking at the overall value of a commercial property beyond just the cap rate. A couple examples are, length of the lease term, location of the property, creditworthiness of the tenant(s), etc.
A large proportion of investors will typically finance a commercial property just because of the amount of capital required to purchase a property. These investors are trying to maximize their cash-on-cash return by using positive leverage. Generally speaking, positive leverage is typically achieved when the cap rate is higher than the loan rate.
So, how does the change in interest rates impact commercial real estate? The simple comparison is to consider looking at the property cap rate and comparing it to the financing that is currently available. One example I discussed with a client was a small multitenant retail center that they were buying for a 6% cap rate (Year 1). They plan to put 40% down and they were able to lock the loan rate at 4.75%. On the surface, this seems like a win. The cap rate is higher than the financing but when you consider the cash-on-cash return, it is actually less than the cap rate, at 5.6%. The current economics made this a negative leverage opportunity the first year. Again, as discussed previously, there are several other factors that go into all of the calculations and my client decided to proceed.
The challenge we are starting to see is when the cap rate and the quoted finance rate are inverted. A recent example was a single-tenant, net-leased property that was being offered for sale at a sub 4% cap rate and all the financing quotes came in over 4%. In that scenario, my client was faced with two options. One option was to pay all cash and not finance the property so that they would have a year one return at 4%. The second option was to look at alternative investment property. This is the pressure that we are starting to see now but as stated previously, it depends on the investor’s objectives and aversion to risk. In this scenario, my client was in an exchange and did not have to replace debt and was looking for a long-term, net-leased property, that was new construction and in a good location. They decided to proceed and purchase the property.
There is always uncertainty and pressure on pricing. Right now, the pressure is from interest rates. Tomorrow, it will be something else. Either way, you have to be able to manage expectations and really consider all aspects when looking at commercial real estate as an investment. It is still one of the best hedges for inflation and helps investors achieve long term wealth.