Low Interest Rates Are the Fuel, But How Long Will They Stay Low?
With the New York City investment sales market rallying, some market participants have been questioning whether the market is approaching a top and if a bubble is being created by our long period of low interest rates. Economic theory teaches us that these conditions do indeed create asset bubbles. History also teaches us that bull markets are born in fear and die in euphoria.
The bull market in commercial real estate, and the equity and bond markets for that matter, have been fueled by unprecedented central-bank support, both at home and abroad. Recent interest rate cuts in Poland, Australia and South Korea have elevated the total number of easings to 510 globally since mid-2007. This has created an artificial stimulus the likes of which has never been seen.
Looking at our investment sales market, it is easy to see that the extraordinarily low interest rate environment has been the primary reason that the market is performing so well in terms of volume and value. Underlying fundamentals are improving gradually; however, the increase in values observed market-wide has far outpaced what the enhancement in fundamentals would dictate.
Much of this upward pressure being exerted on values is due to interest rates.
Many sectors are now far exceeding 2007 levels on a price-per-square-foot basis. Land and retail properties are currently performing best in terms of relative value increases, with multifamily assets not too far behind. The notable exception is Midtown office buildings, but the traction recently within this sector is tangible, and we expect that by the end of the year a new peak will be reached.
So, when will interest rates increase? More importantly, why will they increase? If they increase because of tangible traction in the economy, we all win. If they increase because the money supply in the U.S. has more than quadrupled, the Fed’s balance sheet has tripled and stagflation (a dirty word) sets in, it could get very ugly.
For now, we are experiencing a win-win for commercial real estate market participants. Certain economic indicators are doing well enough to encourage decision makers (not to the extent that they feel we can proceed without the QE safety net), but others remain sluggish enough to keep the Fed’s printing presses operating for three shifts per day. This unevenness is keeping rates low, and low rates are fueling the market, and values have responded.
On a price-per-square-foot basis, value was up 13 percent in 2012 versus 2011, and we expect that it will rise by 20 percent this year. These numbers are significant and translate to 50 to 100 percent returns on equity, given today’s loan-to-value ratios.
While low interest rates are a key to current market dynamics, good old-fashioned supply and demand is also at play here. We are fortunate that, in New York City, demand for commercial real estate assets almost always exceeds supply. In fact, in the nearly 30 years I have been brokering building sales in the Big Apple, supply has only exceeded demand once. That occurred in 1992, when the Resolution Trust Corporation was dumping thousands of properties at fire-sale prices, and there wasn’t much equity around in those days that was targeting commercial properties. After the savings and loan crisis, value diminution reached as much as 70 percent in some sectors, compared with a 38 percent drop this time around.
Generally, supply is very low in the city. In the Manhattan submarket, for example, going back to 1984, the average turnover ratio has been just 2.6 percent of the total stock of existing assets. This means that on average, when an asset is purchased, it is held for 40 years before it is sold. Supply remains low today, but is actually higher than we anticipated it would be in the post-capital-gains-tax-inspired avalanche of selling that occurred in the fourth quarter of last year.
On the demand side, all drivers are in high gear. High-net-worth individuals, families, institutional capital and foreign investors all have guns loaded and truckloads of ammunition to deploy.
The supply-demand imbalance is something we are used to. Our interest rate environment is something that we are becoming a bit too comfortable with, but the longer rates stay low, the longer this rally will likely last. How it all unfolds will certainly be interesting, if not entertaining—and perhaps even frightening—to watch.
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.