November 19, 2018
Commercial real estate prices now stand 26 percent above their prior peak in 2007, but rising interest rates, increasing operating costs, and less robust revenue growth may slow the pace of growth in both prices and net operating income (NOI). For the past six years, the spread between the 10-year Treasury yield and cap rates has provided attractive returns to investors, but since the third quarter of 2016, Treasury rates have risen while cap rates have declined.
For the past six years, the spread between the 10-year Treasury yield and CRE cap rates has provided attractive returns to investors, but since the third quarter of 2016, value has diminished as the spread has narrowed.
Source: Real Capital Analytics, Federal Reserve, Guggenheim Investments. Data as of 9.30.2018.
This has squeezed investors as the cost of debt has increased due to rising rates, but their return over the 10-year Treasury has compressed. In addition, decelerating growth in NOI in all property types other than industrial over the last two years indicates that we may be at a tipping point in values. Investors are adjusting their risk/return objectives by increasing cap rates on new purchases. Evidence of this can be found in quarterly cap rates, which dipped slightly at the end of the first half of 2018.
Investors are adjusting their risk/return objectives by increasing cap rates on new purchases. Evidence of this can be found in quarterly cap rates, which troughed slightly at the end of the first half of 2018.
Source: Real Capital Analytics, Federal Reserve, Guggenheim Investments. Data as of 6.30.2018.
Adding to these concerns, especially for new construction and typical tenant improvement projects, is the rising cost of steel, wood, and aluminum due to ongoing trade disputes with China and Canada. Owners will try to pass on these higher prices to tenants, but nevertheless they will likely see their returns negatively affected. Increased construction costs and higher debt costs could also stifle new development projects over the next two years, which would contribute to the slowdown in the economy that our Macroeconomic and Investment Research Group expects to occur in 2020.
Capital supply has remained well above demand, and we do not see that changing for the remainder of the year. We anticipate a strong fourth quarter for originations for banks, life companies, and Agency lenders. With the recent rise in short-term rates, we see value in five- to seven-year terms in both floating and fixed-rate products. While the bridge market is dominated by private lenders, we are finding conservative borrowers with reasonable debt requests who are willing to pay a yield premium for prepayment flexibility and future proceeds at a fixed interest rate.
—William Bennett, Managing Director; Ted Jung, Director
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Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, and Guggenheim Partners India Management. ©2018, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.
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