Scarcity of Product And Shortage of Quality Pushes Office Cap Rates Lower

Scarcity of Product And Shortage of Quality Pushes Office Cap Rates Lower

Last year, capitalization rates on large office property sales rocketed from the mid-6 range to the mid-8 range. So far this year, cap rates have reversed course, falling back just as rapidly to mid-7 range. Under ‘normal’ conditions, this would imply that property values are increasing. So why isn’t the commercial real estate industry elated?

Cap rates are a benchmark determined by dividing income by property value. Increasing cap rates typically imply that property values are falling. Last year, no one in commercial real estate doubted that the rapid rise in cap rates reflected an equal rapid decline in property values.

However, this year’s decreasing cap rates, which would normally imply rising property values, are being viewed with some skepticism over whether they reflect a long-term trend in values, or simply a short term phenomenon.

According to Fred B. Córdova III, senior vice president / Investment Services Group for Colliers Asset Resolution Western regional team, the current cap rate phenomenon starts with that fact that there is two to three times more capital (debt and equity) in the market than there is product. That factor alone has pushed values up by 20% in three months, he said.

“There is a flight to quality NOI (net operating income) with a rational ‘governor’ that is price per square foot,” Córdova said. “We are seeing some pricing here in Los Angeles (with cap rates) as low as 5% based on market rates. That said, there is a great deal of anxiety out there as to how far cap rates have fallen in the last six months. Foreign money is leading the charge.”

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Watch out for the Muni-Bond Bubble

Nicole Gelinas wrote an excellent article in City Journal about the possibility of a coming bubble-burst in the muni-bond market.

The financial crisis has exploded plenty of long-held beliefs, including the idea that mortgage debt is a risk-free investment. But nothing has shaken the articles of faith that underpin another massive debt market: municipal bonds. Investors in municipal bonds don’t have to worry about a thing, the thinking goes, because the states and cities that issue them will do anything to avoid reneging on their obligations—and even if they fail, surely Washington will step in and save investors from big losses.

These are dangerous assumptions. Just as with mortgages, the very fact that investors place unlimited faith in a market could eventually destroy that market. If investors believe that they take no risk, they will lend states and cities far too much—so much that these borrowers won’t be able to repay their obligations while maintaining a reasonable level of public services. The investors, then, could help bankrupt state and local governments—and take massive losses in the process. To avoid that scenario, investors must take a long, hard look at what they’re doing. Where state and local finances are untenable, they should stop throwing good money after bad.

He explains that there is good reason to be concerned about the muni-bond market. Plummeting tax revenues, and lack of will to cut expenditures on the part of local governments can mean a looming insolvency. Yet the rating agencies still consider muni-bonds low risk. “We do not expect that states will default on general-obligation debt, even under the most stressed economic conditions,” analysts at Moody’s, one of the three major credit ratings agencies, wrote in a February 2010 report. As for cities and towns, “we expect very few defaults in this sector given the tools that local governments have at their disposal.” The firm’s chief competitor, Standard and Poor’s, agrees.

They consider the bonds low risk because they feel the municipalities will do whatever they have to in order to avoid default. They also feel that municipalities have an endless source of funds to repay debt. They can always increase taxes to pay bond debt service.

But, can they?

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