MARKET INSIGHTS
September 16, 2018

Andy Little

RICHMOND TIMES-DISPATCH

by Andrew Little, Special Correspondent

British rock band Faces released its first album in 1970, and it included a hit that aptly describes commercial real estate today, particularly in Richmond.

The song’s title was “Flying.”

Money continues to pour into the real estate sector and, with values steadily higher in most major markets, Richmond is attracting abundant out-of-town capital because its cap rates and values are still viewed as attractive.

The conflicting story lines related to interest and cap rates are providing much to debate.

On one hand, many investors believe that interest rates are moving higher and because of that, cap rates must also march higher, which would hurt values.

In fact, it is hard to see how values on such a capital-intensive investment dependent on debt wouldn’t go down if interest rates go up. In other words, there is justification for concern.

On the other hand, inflation is supposed to be good for real estate, and fear of inflation is exactly what is causing the Federal Reserve to push rates higher. Short-term rates are significantly higher over the past 18 months with one-month LIBOR benchmark interest rate index increasing about 1.50 percent (assuming we get another bump in September).

The confounding part is that over the same period (March 2017 to September 2018), the yield on the 10-year Treasury has increased less than 0.50 percent.

If you are a long-term real estate investor who has locked in a long-term fixed rate, the 1.50 percent in LIBOR has had little or no impact on your returns over the past 18 months.

And since real estate is supposed to be a good hedge against inflation, capital inflows are strong. So there is a good argument cap rates will remain steady while short-term interest rates go up.

Data from Real Capital Analytics, a New York-based real estate research firm, validates the view that values will continue to rise even as interest rates go up.

A recent study of six major markets shows composite values continuing to rise in all but New York, where values have fallen about 6 percent from the peak levels in this cycle.

Research published by commercial real estate brokerage CBRE Richmond also supports the view that values continue to rise even as interest rates rise.

Much of this could be attributed to some underlying fundamentals that are quite good. For instance, in the office sector, CBRE points out that overall vacancy is at a historic low of 9.2 percent, absorption is very strong and rents are increasing, particularly in the suburbs and for Class B space.

CBRE reported much of the same for warehouse space in the Richmond region. Warehouse vacancy is at a historic low of 2.9 percent, average rents jumped 9.9 percent year-over-year, and both absorption and the development pipeline remain strong.

Apartments in Richmond continue to shine as well. CBRE pointed out that absorption during the prior 12 months was extremely strong at 2,134 units, which is nearly double the long-term annual average.

The report indicated that close to 8,000 units traded hands in the past year and the per-unit average sales price was $93,289, a 10.3 percent price increase year-over-year.

June’s trade of the 154-unit First National Apartments building at Ninth and Main streets in downtown Richmond is further support to the theory that values can continue to increase in the face of rising interest rates. The building sold for $39.25 million.

The $254,870 per-unit trade reportedly set a record in Richmond.

The Richmond apartment development pipeline is full, but fundamentals seem to support new construction. Rental growth, strong exit cap rates and record-high average rental rates all have led to new construction, but Richmond seems poised to stay in balance due to rising construction costs and lender scrutiny on marginal deals.

Real estate seems to be the answer to where else are investors going to put money? With long-term interest rates constant even as inflation fears heat up, the sector seems to be in a good spot.

Overall rates remained steadily low over the last month and are currently in the 4.25 to 4.35 percent range for 5- and 10-year loans offered by life insurance companies, according to the John B. Levy National Mortgage Survey.

Conduit pricing is more expensive and ranges from 4.95 to 5.25 percent for 10-year loans depending on leverage.

Let’s hope long-term interest rates remain in check and the industry keeps on flying without too much turbulence.

John B. Levy & Co. partner and investment banker Andrew Little can be reached at alittle@jblevyco.com.