Will the current capitalization rates bubble explode or just have a slow leak? - by John Rynne

How big of a bubble will occur in the continuing low level of overall capitalization rates (cap rates)? I visualize that the generally low cap rates are in a bubble which keeps them artificially low. If the bubble bursts suddenly they could literally explode as if its texture is that of bubble gum. That’s the worst case scenario. In September, 1981 10-year treauries were 15.08% which resulted in even higher mortgage rates. The best case scenario is that the bubble will be durable similar to the exterior of a football and will continue for many years to come. What I see is a slow leak similar to a balloon where cap rates will slowly rise. As long as the Federal Reserve (Fed) keeps purchasing U.S. Treasuries through various types of quantitative easing, the rates will continue to be at a low point. While writing this article interest rates for many stabliized commercial properties are between 3.5-4.5%. Many residential mortgages have interest rates below 3% because of the policies of the Federal Reserve. The problem is the balance sheet of the Fed has ballooned with U.S. treasuries at a very high level. At some point the Fed has to put the brakes on and let interest rates rise.

If the brakes are put on and the Fed stops purchasing US treasuries there could be a “double whammy.” The second part of the “double whammy” will be China. China is the biggest purchaser of U.S. securities outside of the Fed. Currently, China’s annual economy is growing at it’s slowest rate in many years. Part of this is due to the supply chain problems in the United States and other international trading partners. There are tremendous backlogs at the shipping ports in California where container ships are stranded off the West Coast due to lack of truckers. In part, this is due to environmental regulations that were enacted which made mandatory more modern engine requirements for trucks in California. This was not a major problem for large trucking companies to adhere to. However, it was a major problem for small independent truckers who could not afford to upgrade their vehicles to meet these environmental regulations. Thus, many independent truckers stopped servicing California. Some of the bizarre practices that arose out this situation is that the independent truckers would travel to the California state line and unload or load their cargo to and from trucks in California that were environmentally compliant. Of course, this had added to the backlogs and the increased cosst of shipping. This lack of China product distribution has damaged the Chinese economy and is spurring inflation in the U.S.

The other symptom of the Chinese economic problems is a severe real estate crisis. A number of Chinese real estate conglomerates have overbuilt in the market and are defaulting on major loan agreements. As an example, Evergrande which is the largest with $300 billion in liabilities recently took advantage of a 30 day grace period to make a partial payment of $83.5 million toward a $148 bond interest payment. That was the third time within the last month which created concern about their creditworthiness. What does all this mean? It means that higher interest rates could come quicker than was once thought. The combination of A) the need to reduce quantitative easing by the Fed to slow down inflation and B)the need for China to stop purchasing low interest U.S treasuries will result in higher interest rates. Historically low interest rates have been one of the primary drivers of the real estate market in the United States. Of course interest rates are a major player in overall capitalization rates. An increase in interest rates will generally increase cap rates; albeit at a lesser increase but still significantly. As an example, since July 26th 10 year treasuries have increase by 28 basis points. This will put some type of negative pressure on real estate values. However, in late July, 2020 ten year treasuries were at approximately 97 basis points less but cap rates didn’t escalate dramatically. As an example, Rynne, Murphy & Associates, Inc (RMA). has a quarterly rate survey which shows most frequent 2nd quarter 2021 market cap rates to be 6.25%-12.50%. However, as the survey will show, there are extremes outside this range. This survey is based primarily upon properties in Upstate New York and much of western and central New England. The lower end of the range are better stabilized and less risky properties such as class A & B suburban apartment projects. The upper end of the range are applicable to class C hotels, rundown urban apartment projects, etc. RMA is compiling the the third quarter, 2021 survey which will show some small increases in rates, go to the Rate Survey section of the RMA website at www.rynnemurphy.com.

In summary, there is potential for the bubble to burst and cap rates to explode. However, it’s likely the bubble will only have a slow leak

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