IRVINE, CA—With capitalization at historical lows, there is little to no room for more compression and a much stronger likelihood that cap rates will move in a similar direction to interest rates, Faris Lee Investments’ president and CEO Rick Chichester tells GlobeSt.com. As we forge ahead into 2017, we spoke with Chichester about the “Trump Bump” and rising interest rates and how they will affect commercial real estate values in 2017. (Note: Faris Lee’s senior managing partner Don MacLellan and senior managing director Patrick Toomey and Michael Cohen, president of M.A. Cohen & Co., also contributed to this story.)
GlobeSt.com: What are the implications for CRE values in 2017 given current influencing factors?
Chichester: We are in the mature phase of the business cycle, at approximately 90 months in duration–the fourth-longest expansion in US history. Commercial real estate has enjoyed significant recovery and appreciation over this period due to both sustained, moderate growth and the historically low rates as provided by the aggressive monetary policies of the Federal Reserve. Today, much of the commercial real estate sector is “fully priced” and, in some cases, at risk of pushing into the territory of unsupported asset inflation. The fundamentals of real estate have always been critical, but it is also important to understand that its domain is broad and inclusive of economic, social and political influences as well, with no single factor existing in isolation of the others.
GlobeSt.com: What’s your take on the Trump Bump in particular as it relates to CRE values?
Chichester: The Trump Bump follows Donald Trump’s surprising and historical upset in the 2016 election. The election caught many off guard, and it is best to recognize that this was more a vote against the political elite and for an outsider with a “business first” message. Trump is, first and foremost, a businessman, not a politician. His agenda is significant, and it has caught the attention of the market because economic growth and prosperity is at the forefront. His election promise was to balance monetary policy with more-robust fiscal policy through infrastructure investment, reduced regulation (business and finance) and tax reform. The results are a complete reboot of “business as usual.” Since the November election. The stock market is up, 10-year T-Bill down (yield up), and interest rates are rising due to the belief that in the near term, Trump’s policies will lead to economic expansion. However, the questions to be considered as we look into 2017 are: can his campaign promises be implemented efficiently and effectively, can corporate profits catch up to their inflated stock prices and will the expansion of debt cause inflation to overheat?
GlobeSt.com: How do rising rates come into play with respect to CRE values?
Chichester: The market has already begun to price in rising interest rates as the 10-year T-Bill has moved from a low of 1.36% in July following Brexit to 1.7% one day prior to the election, and, as of today, stands at 2.55%. This is coupled with the Fed’s increase of .25% in December 2016, with a promise of up to three more increases in 2017. As rates rise, the implications are significant: is the economy fundamentally secure enough to absorb the increases? With these rate increases, consideration needs to be given to the cost of debt and its impact on yields—CMBS is now underwriting in the range of 4.75% to 5.25%, floating rate debt tied to LIBOR is volatile, life insurance is very selective and banks are underwriting the borrower as much, or more, than the underlying real estate.
GlobeSt.com: So, what should our readers take away from this discussion about CRE values in 2017?
Chichester: With capitalization at historical lows, and giving consideration to the above, there is little to no room for more compression and a much stronger likelihood that cap rates will move in a similar direction to interest rates. There has been a significant recent change in demand. Risk is on the demand side, with capital favoring a “risk off” approach, and acquisitions are becoming far more selective. Debt capital is the critical fuel that drives and energizes the real estate industry, and what happens in the debt market influences the choices of equity. With interest rates rising and a mature business cycle, discipline in debt is promoting discipline in equity.
As we enter 2017, real estate values will be challenged in most property segments, other than core, gateway, high-street “fortress” assets. Value-add will become increasingly more selective in its underwriting, and as much of true value-add is secured by floating-rate debt, there will be even more down-side pressure on pricing due to its volatility. Cautious optimism at this phase in the cycle is the best approach. Capital will not be chasing deals under the sheer pressure of getting capital out, but will be more disciplined and selective. Values will be far more dependent on the fundamentals of real estate and the relevance of tenants’ businesses and their customers. Core will remain in high demand, but all other properties will be at risk of repricing to the down side. Knowing the factual strengths and challenges of the asset is critical, and being grounded in the fundamentals is an absolute. Following these principles, along with operational excellence, will preserve value and promote long-term growth. The days of cap-rate compression are most likely behind us, the economy is 90 months into this business cycle, and risk is on the demand side. Cautious optimism is the outlook for 2017 as Trump promotes his agenda for economic growth.