Todd Kuhlmann, CCIM and CEO/President of CRE Tech, Inc., joined me at the National Association of REALTORS (NAR) Annual Conference in San Diego to discuss the impact of rising interest rates on commercial real estate and more specifically, on cap rates.

 

Currently, there is talk of a bubble and speculation that people are overpaying with cap rates at an all-time low. Cap rates drive the value (not the return on the investment, but the value of the investment). So what the low cap rates mean are that prices are really high right now. Kuhlmann said institutional investors can pay high prices (and low cap rates) when the cost of capital is so low (as it is now) but when the cost of capital starts increasing, something’s got to give.

 

Everyone is waiting with bated breath for interest rates to rise and there is speculation that it could be this month. Kuhlmann said, “We know it’s going to happen. The million dollar question is when.”

 

Instead of trying to figure out when it might happen, Kuhlman’s advice is to be aware and make adjustments now. “You can make money in real estate in an up and down market as long as you know what to predict,” Kuhlmann said. 

 

When you are doing commercial real estate projections the number one variable is what you are going to sell for and when. And the 10-Year Treasury rate is the best indicator of the cost for capital. “As it goes up the cost of capital goes up in the commercial real estate world,” said Kuhlmann. Currently the 10-Year Treasury rate is 2.3% but he points out that the long-term average yield on the 10-Year Treasury rate is actually 6.4%.

 

So with a slight rise in interest rates, the commercial real estate industry won’t halt – but there will be corrections. Investors are still buying properties and they are already using exit cap rates that are higher than the going in rate. 

 

As interest rates go up, Kuhlmann says “expect to see a push on returns that are required of institutional investors. If the cost of capital goes up and the required return has to remain the same, then what’s going to change? What they can pay for the property.”

 

These type of investors have a required discount rate, otherwise known as a “yield requirement,” and they have to earn that much money to meet their obligations. Examples are a life company, they have to pay out life insurance or a pension fund has to pay out pensions. 

 

A lot of investors are banking on improving the NOI or that there is simply enough growth that we’re going to be ok. Kuhlmann agreed that “the demand is there” and, logically, there will be more emphasis placed on NOI since the cap rate is a method of calculating the value based on NOI. “In Austin, Texas we’ve been figuring out every way to suck every dollar out of every property,” he said. 

 

However, he points out that you have to compare demand drivers to interest rate indexes and “look at all of it” to determine what you can sell a property for in the future and what the return is going to be. 

 

Kuhlmann is predicting a “correction”, not a crash. Even though values are higher than 2008, smaller tertiary markets may have just hit the cycle and these markets may have some ability to increase the NOI over next few years so the interest rates adjustment won’t affect them as much as a market that has already adjusted its pricing. 

 

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