Credit-market swoon sends somber message to property investors

by 07 Dec 2015
Commercial real estate investors are receiving ominous signals from the bond market.
Yields on U.S. corporate debt are rising -- touching a three-year high last month -- while projected returns on properties from apartment towers to offices to top-tier shopping malls stay stubbornly low. The narrowing divide suggests that, after five years of gains, prices may start to slide as other types of investments become more attractive, according to research firm Green Street Advisors LLC.

The hunger for risk that’s pushed up commercial real estate values is fading as the Federal Reserve prepares to raise interest rates for the first time in nine years amid mixed readings on global economic expansion. Property investors are showing more caution and price appreciation is already slowing, said Andy McCulloch, an analyst at Green Street.

“People are a little more worried about the overall direction of the economy,” he said. “The frenzied environment has stopped.”
On average since 1986, commercial-property owners could expect to get paid about 150 basis points more than they would get buying debt issued by companies with good credit ratings, data from Green Street show. As of Dec. 1, that gap had shrunken to 54 basis points, or 0.54 percentage point.

Real estate values have been surging since 2010, fueled by cheap loans, a global hunt for yield and a flood of cash from foreign buyers seeking havens. The most desirable office properties in cities such as New York and San Francisco are fetching prices that are 57 percent higher than at the height of the previous boom in 2008, according to Moody’s Investors Service and Real Capital Analytics Inc.

The relentless climb has sparked speculation that a fall may be imminent. The Fed, in an October presentation, highlighted commercial real estate values as potentially showing signs of overheating.

Investor Questions
 
“Several years of substantial growth naturally leads to questions about where we are in the cycle,” Jonathan Mazur, managing director of research for brokerage Newmark Grubb Knight Frank in New York, said in an interview. “The world doesn’t have to fall apart for there to be a correction.”

Real estate has benefited from low yields for bonds in recent years as investors pushed into riskier assets to boost returns. As corporate-debt yields rise, owning office buildings looks relatively less alluring.

Green Street analysts aren’t predicting a dramatic crash. In a report last month, the Newport Beach, California-based firm forecast that commercial-property prices will be about 5 percent lower in a year based on readings of the corporate-bond market and the steep discount in shares of real estate investment trusts relative to the value of their holdings.  

‘Very Vigilant’

“Volatility in markets is a sign that we need to be very vigilant,” Martha Peyton, co-head of global research at TIAA- CREF, which manages $89 billion in real estate assets, said in an interview. “It is a sign of increasing investor caution, but in order for that to become a sea change, something substantial would have to happen.”

There are mitigating circumstances that may push real estate prices even higher, according to McCulloch. The fundamentals underpinning commercial-property values -- rent and occupancy growth -- remain on the upswing, and private equity firms and overseas institutions with record stockpiles of cash are still targeting U.S. real estate.

Barring an economic shock such as a recession, property values should hold up, according to Peyton of TIAA-CREF. For foreign buyers seeking safety, a growing force in the market in recent years, long-term stability is more crucial than short- term returns, she said.

Office Prices

Price appreciation has already started to slow. The trend is most evident in office-building values, which have climbed about 5 percent this year, down from 15 percent in 2014, according to Green Street.

Changes in commercial real estate values take longer to spot than shifts in the bond market because buildings don’t change hands as often as securities do. Capitalization rates -- a measure of real estate investment yield that falls as prices climb -- have leveled off after declining for five years, according to Green Street. That indicates buyers are becoming wary of the record-low yields on property investments and may soon demand higher returns, pushing down prices.

“People are less willing to reach,” McCulloch said.

©2015 Bloomberg News

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