Commercial Real Estate: Is Core Overheated?

Eager investors are pushing cap rates on well-leased, Class A properties in top-tier coastal cities to their lowest levels since 2007.

March 1, 2011

Does the drop signal a widespread commercial real estate recovery? Or is it the beginning of a mini bubble? Robert White, CRE, CEO of New York–based Real Capital Analytics, weighs in.

What factors are contributing to the rapid price increase and cap rate declines in core commercial properties? 

Capital is looking for yields, and real estate is offering pretty attractive returns compared with money market funds or the stock market. Real estate also has a special attraction as a hard asset, which makes it valuable as a long-term hedge against inflation. So everyone is concluding: “If I can buy a well-located, stabilized office building in a large, high-barrier-to-entry market, my risk is low.” That’s pushing up prices.

So it’s a familiar story of a lot of capital chasing relatively few properties?

 There’s definitely a concentration of capital looking for core office. In 2010, about 75 percent of the deals tracked by my company were core property purchases in markets like New York and San Francisco. The competition for product is producing cap rates in the mid-5 range. That’s a big spread when you consider that the average office cap rate nationwide is closer to 8.

Are these lower cap rates justified? 

A lot of my clients ask me that. I don’t think most buyers will have to worry about overpaying. Even at a 5 1/2 cap, there’s a 250-basis-point cushion in the risk premium spread over 10-year Treasuries. In 2006, when we last saw cap rates this low, properties were trading at cap rates at or below Treasuries. Add to that the interest rates at near historic lows and an investor can still have positive leverage.

What about fundamentals? Do they justify the price increases? 

Fundamentals are going to improve, and since most of today’s institutional and REIT buyers are looking at much longer time horizons than buyers were a few years ago, they have time to wait.

Do you expect current investors to keep bidding up core office prices in 2011? 

No, the gap in the market in core pricing between first- and second-tier cities is already beginning to close. Investors—especially nontraded REITs, which have more geographic flexibility than some publicly traded REITs and institutional buyers—have already started to look for alternatives that provide higher yields. At the end of 2010, you were beginning to see more investment in core office properties in smaller cities like Minneapolis, Richmond, and Salt Lake City. The loosening of the credit crunch and the revival of the CMBS market should also support investment in smaller cities. The loosening of the credit crunch and the revival of the CMBS market should also support investment in smaller cities.

We’ve focused on the price appreciation in office buildings. Are you seeing similar higher prices and lower cap rates in retail and industrial properties? 

To a certain degree, yes, especially in larger retail centers with a grocery or big-box anchor. Over the last nine months, we’re beginning to see trades at cap rates in the mid-6s. Some of the same investors that have been bid out of a trophy office property have started to look at retail. Industrial has been more of a laggard.

Mariwyn Evans

Mariwyn Evans is a former REALTOR® Magazine writer and editor, covering both residential brokerage and commercial real estate topics.