Real estate activity still near record levels, but beware of cap rates and the “canary in the coal mine” by John Rynne

John Rynne, Rynne, Murphy & Associates, Inc.

Overall capitalization rates (cap rates) are always the topic of discussion in real estate appraisal circles. We are still in the midst of some of the most historically low cap rates in modern history. The cap rates are directly related to the lowest interest rates in my 43 years as an appraiser. The effect of the low interest rates has driven one of the most active real estate market in 30 years in the northeast United States. This is especially true in New York City where real estate values are exploding. Of course New York City has substantial influx of new residents. This influx has increased the need for housing units especially low income and middle income. Local, state and federal agencies has provided many grants, tax credits, low interest loans for many types of projects; especially for low and moderate income housing. Also, there is much foreign money buying up real estate as an investment and as residences. In other parts of the northeast outside of New York City and Boston, there is not as much of an influx of new residents, jobs, and foreign investors; so interest rates are the primary mover of an active real estate market. Are there any “canary in the coal mine” indicators which will outline a major change in cap rates fueled by higher interest rates.

Based upon a recent news story cited in the New York Post, the Middle East Qatar Investment Authority purchased a 9.9% interest in the trophy property, Empire State Building, for $622 million which if extrapolated to 100% mathematically would result in price of $6.28 billion or approximately $2,285 per s/f. Ironically, a former trophy property in Buffalo, New York which is now known as One Seneca Tower, originally constructed by Marine Midland Bank 43 years ago, reportedly is under contract for $12 million or $14.11 per s/f by a Washington D.C. developer. This 38-story building is one of the largest and tallest office buildings in Upstate New York. To be fair and balanced, this building is almost 100% vacant. However, even when it is was fully occupied in 2005, the sale price was less than $100 per s/f. This shows the huge disparity between the big urban markets of the Downstate New York, Boston and smaller markets of Buffalo, Rochester, Syracuse, Binghamton, Albany, Hartford, Springfield, etc. that even the record low interest rates won’t reduce. Thus, nothing can substitute the huge demand factors of international investors, jobs and population increases.

One of the reasons for the demise of One Seneca Tower is competition within the Buffalo downtown office market. There have been substantial new office space created by a combination of new construction and rehabbed older space which has been subsidized by tax credits, low interest government loans, government grants, etc. The positive aspect of this is that it acts as a short term catalyst to spur activity and keep rental rates low enough for attracting tenants and owner occupants from older buildings. Of course some of the older buildings like One Seneca Tower had some functional obsolescence because of age and had 850,000 s/f of space which makes it a large fish in a small pond. I use this as example similar to that of a “canary in a coal mine” which is starting to lose oxygen. The point is; without more than low interest rates the success of smaller markets is dubious if there is not an influx of international capital, jobs and population. The Federal Reserve Bank headed by Janet Yellen is expected to increase rates before the end of the year ever so slightly which should result in continued low cap rates which will keep sales activity and prices relatively high even in the secondary markets. However, the Federal Reserve has some of its own problems. Their holdings of U.S. treasuries, etc. are approximately $6 trillion. This is an increase of over 600% over the past 7 years. Some think this is a house of cards or type of Ponzi scheme; and is a policy which is not on solid financial ground. However, this strategy has kept interest rates artificially low which not only has encouraged borrowing for new projects but also boosted the stock market to record highs and real estate cap rates at all time lows.

One thing is for certain; real estate activity is still at near record levels in the big markets and smaller metropolitan areas in part because of low interest rates and government intervention for the foreseeable future. However, look out for the “canary in the coal mine” example like Seneca Tower in your local market which may fuel a major change in Federal Reserve policy and cap rates.

John Rynne, MAI, SRA is the president and owner of Rynne, Murphy & Associates, Inc., Rochester, N.Y.