Since the financial crisis began back in the summer of 2007, the Federal Reserve has lowered interest rates to zero and embarked on multiple rounds of Quantitative Easing programs. A QE program is when they print money and enter the market to purchase assets. Their two assets of choice during QE 1 & 2 have been mortgage bonds and treasury bonds. By purchasing these bonds and adding trillions of new liquidity into the market, yields have been driven down to artificially low levels.
This has many benefits to the economy. Home buyers can purchase homes with lower monthly interest payments. Businesses can borrow at a lower cost. Our government has the ability to finance multi-trillion dollar deficits annually, which allows tax cuts and stimulus programs to flow into the economy.
It also has other “side effects.” By driving interest rates lower, it punishes investors who hold money in cash (save money) or live on fixed income payments. It pushes Americans who are retired into riskier assets in order to try and generate a return on their money that they can live on. For example, there has been a recent rush back into junk bonds, blue chip stocks, and municipal bonds - which all generate a higher return than short term government bonds or cash.
The same effect has been seen in the commercial real estate market. Investors look across the spectrum at their asset class options and see that commercial real estate provides the opportunity to generate somewhere between 4% and 10% on their money depending on type of property and location they choose to buy. The following table from RealtyRates.com shows the current average cap rates for the major commercial real estate property sectors. Click for larger view:
Remember Mike, our potential investor from the previous example? With interest rates at 0%, Mike is willing to pay a higher price (purchase with a lower cap rate or return on his money) than he otherwise normally would. If more investors begin to enter the market, they will begin to compete for these yields. This is what has happened over the past few years in the apartment industry and the A+ property sectors in top markets.
Investors are starving for yield. They have entered back into the market with force, seeing low interest rates and watching the stock market rise. What they are not seeing is the shadow inventory lingering over the market.
Let's say that Bob the investor buys an A+ property at a 4% cap rate (this is happening every day in some of the strongest markets). The ten year treasury bond rises from 2% to 4% (still very low in historical terms). Bob has raised his rents, reduced expenses and put his building back on the market because he reads that the economy is doing very well in his area and investment capital is continuing to come back into the real estate market.
Mike the investor comes to town and is looking to put money to work. Mike has the option of purchasing Bob’s building at a 4% cap rate (which he must then manage), or he can purchase a 10 year treasury bond and collect 4% per year with absolutely no work (the 10 year treasury bond is considered a risk free investment because it is very unlikely our government will default on the debt).
Mike and other potential investors who could've purchased Bob’s building decide they would rather purchase treasury bonds. Bob is shocked that his building is sitting with no activity. He must now lower his offering price (to provide a 5% or 6% cap rate) in order to compete with treasury bonds.
Even with an increase in rents and a reduction in expenses, Bob may still be underwater on his investment. To repeat, investors are purchasing commercial real estate today with no consideration on the future direction of rates. These rising rates will provide the next leg down in pricing just as the first round of extend and pretend assets begin to hit the market.