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Thread: Rising interest threaten building prices

  1. #1
    Forum Veteran krulltime's Avatar
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    Default Rising interest threaten building prices

    Rising interest charges threaten building prices
    Higher rates could shift power to long-term investors from big-time borrowers

    By Judy Temes
    Published on June 07, 2004

    Real estate broker Jeffrey Dunne hadn't seen buyers reduce their offering bids on a commercial property in years--until now.

    A sudden jump in long-term interest rates in recent weeks, and the prospect of worse to come, was enough to force one bidder to quickly shave $1 million, or 5%, off his offer of $22 million for a New York area office property.

    "Buyers, especially highly leveraged buyers, are starting to change their pricing in response to the higher rates," says Mr. Dunne, head of the tristate investment sales group at CB Richard Ellis.

    Price cuts in sight

    A superabundance of money available at stunningly low interest rates has helped keep property values on a rising track since 2000. But as borrowing costs begin to creep up, there is growing concern that building prices could take a hit. At the same time, rising rates could also signal a long-awaited shift in power toward traditional long-term investors and away from the highly leveraged buyers who have dominated the market for the last several years.

    "The money won't stop flowing," says Ron Cohen, executive director at Cushman & Wakefield Inc. "But the source of it may change from leveraged private buyers to hedge funds or investors with more cash or equity."

    So far, the impact is only beginning to be felt. But with the interest rate on benchmark 10-year Treasury bonds hitting nearly 4.7% recently, compared with a low of 3.1% a year ago, it is only a matter of time. How great the impact will be obviously depends on how high rates stretch. But several real estate experts predict that if rates on Treasuries add another point, forcing commercial mortgage rates to 7% or more, the price of office buildings could drop 5% to 10%.

    "Building prices have already stopped going up," says Woody Heller, executive managing director of Studley's capital transactions group.

    Other factors

    But whether prices actually drop will depend on more than interest rates. Strong economic growth could give landlords room to raise rents, which in turn would help property values. Experts note that a relative dearth of new construction in recent years has kept the supply of available space tight, which again should help maintain prices.

    At this point, with borrowing costs rising, property owners have little choice but to react. Many are taking steps to insulate themselves from future rate rises by switching their borrowing into fixed rate from floating rate. Jeffrey Lee, a special counsel at Cadwalader Wickersham & Taft, reports that he has been inundated with such transactions. One of his clients, Deutsche Bank, has 60 refinancing deals pending-double the norm. "It's like everyone trying to get on a rush-hour subway car at the same time," he says.

    Another big player in the market has seen a similar surge. Last year, Wachovia made commercial real estate loans totaling more than $4 billion in the New York market. Two-thirds of those were at floating rates. In recent weeks, however, the bank has seen a 30% surge in the number of requests for fixed-rate borrowing, according to Robert Verrone, managing director of the North Carolina-based bank.

    The rationale for the stampede into fixed-rate borrowing is clear. For example, a 2 percentage point increase in the effective rate of a $100 million loan would add $2 million each year in carrying costs. "If the revenues on their buildings stay the same, where is that money going to come from?" asks Jeffrey Steiner, who heads the real estate practice at law firm Brown Raysman Millstein Felder & Steiner.

    Now, those higher costs must be factored into bidders' building valuations. In fact, the odd thing about the market for New York office properties in the last few years has been how well it has done in the face of blows that normally would have driven prices down.

    Hitting a high

    By the first quarter of this year, Class A vacancy had risen to 8.1% from 3.3% in the same period of 2000. In the same span, average rents had slipped to $48 per square foot from $50 per square foot, according to Cushman & Wakefield. Instead of falling, though, prices of top-quality buildings shot up to a high of $524 per square foot in the third quarter of last year from $291 per square foot in the third quarter of 2000, according to C&W.

    Observers expect older buildings with high vacancies to be the most vulnerable to price depreciation. In contrast, the value of Class A buildings is likely to do better.

    For highly leveraged owners, who in many cases put up less than 10% of the purchase price in cash, the future is looking stormier by the day. For those who borrowed at floating rates, Mitchell Rechler, president of developer R Squared, says "profit margins will narrow, and that could ultimately cost them their buildings."

    Stormy future

    On the other hand, such forced sales could at last provide an opening for others. "Some of us older investors have been locked out of the market by the riverboat gamblers," says Jeff Gural, chairman of Newmark & Co. Real Estate Inc.

    Another person in that position is Anthony Malkin, president of W&M Properties Inc. He reckons that in the past few years, he has been outbid 20 times by rivals who had gorged themselves on cheap loans and who were willing to accept a return on their money of as little as 5%, as opposed to the 8% he aims for.

    Now, Mr. Malkin sees rising rates as a call to arms. "It will make people who borrow less competitive and play into the hands of people with equity," he says.

    Copyright 2004, Crain Communications, Inc

  2. #2
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    Feb 2003
    New York City


    This is one reason why the real estate market is so hot right now. Money is cheap with interest rates so low. When they rise, the market may cool. It has to at some point.

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