I received many emails and calls about the last sentence of last week’s column. That sentence read, “Low rates have been the rocket fuel for a sales market that is currently white-hot and, as long as rates continue to stay low, will continue to be, notwithstanding that this condition is completely artificial.”
Many of the responses contained examples of how fundamentals have rebounded and how the recovery in the commercial real estate sales market is based upon much more than a low interest rate environment. Many comments also revolved around how we are in a new normal in which interest rates are low and will stay low for years and years.
Here is why I believe that the artificially—yes, artificially—low interest rates are the major contributor to the tremendous activity seen in the commercial real estate sales market and not a recovery in underlying fundamentals.
First, let’s look at supply and demand dynamics. On the demand side, things haven’t really changed much since 2010. Demand has greatly exceeded supply and all demand drivers are in overdrive. When the institutional capital, which inflated the asset bubble in 2005-2007, all but evaporated in 2008, the overwhelming majority of buyers were high-net-worth individuals and the New York families that have been active in the market for generations. By 2010, this institutional capital re-emerged with a vengeance, having raised billions for distressed assets and opportunistic acquisitions, joining the high-net-worth investors and families who have remained resilient.
Joining these buyers is a throng of foreign investors from all over the globe who are looking for the relative safety of our economy and the relative stability of our political system (relative is the operative word here). This foreign demand has been extraordinarily high, but fairly consistent, over the past few years.
Based upon the above, we believe the demand metric, while great, hasn’t improved much recently.
On the supply side, we did see an increase in supply last year as sellers chose to take advantage of a low capital gains rate environment. As anticipated, the supply of available properties for sale has moderated, but we expect supply to normalize as we head into the second half of this year. Not much of a tangible change here.
Second, let’s look at rent levels. Office leasing is probably the commercial real estate metric most sensitive to the broader economy. As the economy has just been limping along, it is not surprising to see that, while we have experienced some moderate improvement in commercial office rent levels, they have not been growing near post-recession trend levels. Tenant demand also remains well below normal trend levels.
Rent levels in residential properties are increasing nicely, particularly in new buildings. The lack of a steady stream of new product over the last several years has much to do with this. Unfortunately for this product sector, despite rising rents, net operating incomes have remained relatively flat as real estate taxes and other operating expenses have escalated dramatically. Here, the fundamentals have gotten moderately better.
Retail rents have increased tangibly, particularly in the best locations. Here the fundamentals are having a real impact on the market.
Our interest rates are low because the Fed has implemented QE1, QE2, Operation Twist, QE3 and now QE Infinity. These initiatives are keeping rates low. There is nothing market-driven about these low rates. Historically low rates are, completely artificially, kept that way by policies that have quadrupled the U.S. money supply and allowed the Fed’s balance sheet to more than triple.
Furthermore, most investors are basing what they pay for properties today upon the low borrowing rates they are able to take advantage of. If one doubts that these low interest rates are indeed the rocket fuel propelling the sales market in New York today, let’s see what happens when rates rise. Unless healthy traction in the economy is the reason why rates rise, the result is likely not to be pretty.
As I remind all of my brokers on a weekly basis, “Every day interest rates stay low is a good day.”
Robert Knakal is the chairman and founding partner of Massey Knakal Realty Services; in his career he has brokered the sale of more than 1,300 properties, with a market value in excess of $9 billion.