Prices of commercial real estate are rising rapidly, spurred in part by an influx of foreign money. As a result, cap rates have declined to historically low levels. Have prices risen too rapidly? What are the risks of a sharp correction in the months and quarters ahead, especially as the Federal Reserve contemplates an increase in short-term interest rates? The Wall Street Journal recently flagged these concerns; see “Surge in Commercial Real-Estate Prices Stirs Bubble Worries,” August 13, 2015.
Market factors can alleviate some, but not all, of these concerns. While cap rates are low, their spread to Treasuries is in line with prior historical periods that were not followed by a price collapse. Cap rates, of course, should be expected to rise as Treasury yields eventually increase. The key question is whether rising cap rates occur due to a drop in property prices (the denominator in the cap rate calculation), or whether rising income from properties (the numerator in the cap rate calculation) allow cap rates to drift higher.
Economic fundamentals suggest that rising income from commercial properties will drive cap rates higher. In a world where payrolls rise 200k+ every month and construction activity is rising but still moderate, rent growth is likely to accelerate and occupancy rates will move higher. This will translate into NOI growth that will allow cap rates to drift up as Treasury yields rise.
What about concerns that excessive debt growth is pushing prices to an unsustainable level? While lending is up from a few years ago, leverage is still moderate. Commercial banks are increasing their lending, as are balance sheet lenders (i.e. insurance), but CMBS issuance is only keeping pace with the refinancing of the 7 year bonds issued through 2008. So a credit binge does not appear to be driving prices to unsustainable levels.
This all suggests that current prices are not overinflated—yet. Prices of commercial real estate could become vulnerable, though, if (1) price growth accelerates and remains elevated through, say, 2016 and beyond, getting too far ahead of fundamentals; (2) transactions are funded increasingly with debt, and underwriting standards slip further; (3) construction continues rising at a double-digit clip without showing signs of slowing; or (4) some other shock hits the economy, job growth stalls, and weak macroeconomic growth or outright recession takes out the demand for commercial real estate.
In short, the recent rapid growth in commercial real estate prices appears to be well supported by improvement in fundamentals. It will be important to follow price trends, credit growth, new supply and economic fundamentals to gauge whether prices begin to get too far out of line in the future.