Bankers Are Worried About Sky-High Commercial Real Estate Prices

By Noah Buhayar

October 11, 2018, 5:00 AM EDT

Janet Yellen recorded the warning a day before stepping down as Federal Reserve chair in February: Commercial real estate prices look strikingly high. Her successor, Jerome Powell, flagged it again a month later.

Analysts at Goldman Sachs Group Inc. tried in May to put a number on it: Properties may be overvalued as much as 16 percent. Soon, Wells Fargo Chief Executive Officer Tim Sloan went on television, saying some deals looked “frothy” and that his bank was pulling back. In the past month, executives at regional lenders including U.S. Bancorp and KeyCorp have chimed in with similar concerns.

Yet, by some key metrics—most notably default rates—the market seems serene. So why all the handwringing?

Years of economic growth and easy financing have pushed prices for office towers, apartments and warehouses to record heights. Executives speaking out say they’re worried some buyers are betting too boldly that they can just keep raising rents.

Source: Real Capital Analytics National Commercial Property Price Index

But that’s not all.

Normally, banks would tap the brakes on lending, and the market would cool. But since the 2008 financial crisis—when banks became more disciplined—other lenders have muscled in and are keeping the financing flowing. They include debt funds with multibillion-dollar warchests that aren’t subject to the same level of oversight. Some are competing with aggressively low rates and terms. Now even some banks, under pressure to compete, have loosened standards in recent quarters, Fed surveys show.

The availability of cheap debt helps investors stretch on price. Observers can see it in capitalization rates. Put basically, cap rates are a property’s investment yield—making them the favored metric for gauging real estate prices. It’s a simple calculation: Divide net operating income (rent minus expenses) by a building’s value. They’ve been going down significantly for most property types.

At these levels, buyers of commercial real estate today are, in effect, settling for thin returns or betting they can improve yields over time by persuading tenants to pay more. A 47-acre office park in Santa Monica, California, recently traded hands at such a high price that the expected yield is just below the buyer’s cost of debt. That means the new owners, led by Boston Properties Inc., will have to boost rental income. A large, diversified investor can place and see through such calculated bets. It’s harder for smaller speculators.

Source: Real Capital Analytics via Bloomberg

Low cap rates have also pushed some investors into less popular corners of the market. Sales of offices in Cleveland more than doubled last year from 2016, in part because the Rust Belt city offers higher yields than faster-growing metros. Resorts—a class of properties that was hit hard during the recession—are finally making a comeback. And niches like student housing and retirement communities have seen investment surge so much that their cap rates have fallen, too. Some investors are now snapping up hospitals and nursing homes.

Prices also have been buoyed by low supply in many markets, exacerbating a dramatic slowdown in new construction after the financial crisis. Over the past decade—and still—that has kept occupancy rates high for many types of properties. But there are pockets where there’s too much square footage—especially in retail, as shoppers buy online and chains go bust.

Note: YTD through Sept. 28, 2018

Source: Trepp

In other areas, supply has recently caught up with demand. That’s the case with apartment buildings. Rents in many of the largest metro areas have been leveling off. The reasons vary: In some markets, tenants just can’t afford more. Builders also have sought profits by neglecting affordable housing and bringing too many high-end units online. Landlords in Seattle, long a hot rental market, are now desperately luring the city’s burgeoning hoard of coders with $6,000 gift cards and free electronics.

Note: Annual change in average rent, though August of each year

Source: Zillow

To be clear, financial industry leaders aren’t saying a crisis is already unfolding—just that they aren’t going to pursue as many deals in the present environment. Building owners aren’t buckling under debt like they did a decade ago, when a real estate downturn almost toppled the global banking system. Loan defaults remain rare.

And so money keeps flowing into the market. This week, Deloitte predicted the volume of commercial real estate transactions will jump 13 percent in the next 18 months. Private equity firms keep raising substantial war chests to acquire properties. It all suggests there are both buyers and cash waiting in the wings.

Bankers Are Worried About Sky-High Commercial Real Estate Prices

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