LOS ANGELES-Treasuries and spreads gapped out, adding almost 1.5% to headline interest rates since the trough. Now spreads are tightening, but the new equilibrium is at a higher all-in rate. Are there consequences?

Interest Rates

Summer has so far proven to be a mercurial season for the real estate capital markets as capital costs fluctuate in response to macro-market indicators and the Fed Chairman's comments. The market initially overreacts to news and the pendulum swings too far; 10 year CMBS spreads for example spiked almost 50 basis points in a very short time period from a low in early May. But as the dust settles and lenders become comfortable with the “new normal” they slowly venture back into the market, where competition and pressure to transact is leading to a gradual return to tighter spreads as lenders fight to win business. All-in coupons will likely not return to the lows of early 2013 due to the increased Treasury Index that appears to be on a steady upward trajectory due to long-term macro-market conditions, however the premium CMBS lenders charge over this Index could return to early 2013 levels barring further market shocks.          

Loan Proceeds

The rise in interest rates has not yet significantly impacted loan proceeds. CMBS loan amounts are constrained by a combination of metrics including the lesser of a loan's a) debt yield, which is the ratio of a property's NOI to the loan amount and excludes an interest rate measure, b) debt service coverage ratio, which measures the amount of excess cash flow after debt service, and c) loan to value. In recent years a property's debt yield has served as the predominant limiting factor on loan proceeds in markets with low cap rates because the other two metrics have been so far out of the money. As interest rates continue to rise however lenders will start to bump up against the DSCR constraint. While the loan to value metric is less immediately impacted by recent market movement higher interest rates could result in a rise in cap rates that puts downward pressure on values and consequently on allowable leverage, which will affect returns for both debt and equity.

The Effect of Rates on Returns

In reality cap rates may not move much even with upward pressure on interest rates, and due to a combination of historically outsized returns and continued demand the market will likely continue to transact despite potentially diminishing returns. Investors have been getting an outsized return on equity (“cash on cash return”), in part to compensate for additional perceived risk in an unstable economy. The interim period as the market finds its new equilibrium after a rate shock is rocky as investors retreat to core assets in major markets, there is less tolerance for “story deals”, and investors demand a higher return. Now that the economy is perceived to be recovering the demanded returns are decreasing. Additionally there is a glut of capital allocated to real estate as an asset class; equity continues to be raised and demand is high despite the recent volatility. A combination of the relative robustness, stability, and transparency of the US economy as compared to international alternatives coupled with the tangible nature of buildings versus other asset classes results in the continued perception of US real estate as a “safe haven” investment. In conclusion, the recent increase in interest rates has not impacted demand for real estate as an asset class to date. Loan proceeds have remained relatively consistent, and the market continues to transact.  

 Gary E. Mozer, is a principal and managing director of George Smith Partners. The views expressed in this column are the author's own.