Commercial investment real estate: Opportunity in smaller markets

by Bill Small, Aspen Daily News Columnist

Sunday, March 24, 2013

Commercial investment real estate has made a comeback since the depths of the Great Recession in 2009. But as more and more investors come back into the market, returns are dropping precipitously in the major real estate markets around the country. The primary and gateway markets consisting of large cities such as New York, Washington, Chicago, Boston, Los Angeles and San Francisco, and secondary cities such as Denver, Houston and Atlanta, are starting to see capitalization rates on acquisitions and overall returns again decline to historically low levels not seen since just before the recession started in 2007 and 2008. These low returns are being driven by a combination of historically low interest rates and demand from well capitalized investors looking for good buys.

The risk is that interest rates are very likely to trend higher in the next few years, pushing up yields and investment real estate capitalization rates. Mortgage interest rates are typically priced off the 10-year U.S. Treasury bond rate. The current 10-year U.S. Treasury bond rate is 2.1 percent versus the long-term average yield for the 10-year bond of 6.64 percent. At some point interest rates will return to the average and capitalization rates will increase as well. As capitalization rates increase, the value of an investment property will decline. For example, a 100 basis point (i.e. 1 percent) increase in the market capitalization rate from 6.5 percent to 7.5 percent would result in a 13.3 percent decline in a property‚Äôs value, if all else stays the same. Read more…