WV Executive

In early 2001 the commercial real estate market peaked, only to be followed by two years of struggle. This peak occurred when the Federal Reserve raised interest rates in an attempt to slow the United States economy. A renaissance followed two years later as a result of interest rates hitting new lows; in the Federal Reserve’s attempt to jump start the economy.

This leads to two questions: how much impact do interest rates have on the health of the commercial real estate market, and does the overall wellbeing of the United States economy play a greater and more positive role in commercial real estate? Because interest rates and economic activity are not mutually exclusive, their effects play direct and indirect roles within the commercial real estate market.

From a historical perspective interest rates appear to have a direct impact on activity within the commercial real estate market—especially commercial construction. Consider the peak in commercial real estate construction in the first quarter of 2001: commercial office buildings under construction in the United States totaled $57 billion. Prior to this peak in activity, interest rates were raised in response to the Federal Reserve’s anti-inflation moves enacted in 1999 and 2000. By the fourth quarter of 2003, total commercial construction had fallen to $32 billion, and the Federal Reserve was drastically lowering interest rates at the same time. Where is the direct relationship between interest rates and commercial real estate activity?

Interest rates play a leading role in the valuation of commercial real estate, both existing and proposed (new construction). One method of determining existing commercial property values is net operating income (NOI). Under the NOI method, market value is equal to the present value of all future income. Once the annual NOI is determined, a market capitalization rate is estimated by analyzing recent and similar market sales.

NIO/Sales Price

The capitalization rate will provide the current demand rate of return. This is where interest rates will have an impact on commercial property values. During periods of high interest rates, combined with high vacancy rates, high unemployment and declining rental properties, the estimated NOI on similar properties will produce lower sales prices and corresponding higher capitalization rates. Thus, in market terms, it is a buyers’ market for commercial property. If the scenario is reversed, whereby interest rates are low, vacancy rates are low, unemployment is low and rental rates are increasing, the increase in annual NOI and lower capitalization rate produces higher market values and subsequently, a sellers’ market exists.

Under most conditions, the purchase of commercial real estate involves debt financing, as opposed to an all-cash transaction. From an investment valuation standpoint, the most utilized method of valuing commercial property is after tax cash flows (ATCF). The major advantage to this method versus NOI is ATCF takes into consideration the use of debt financing in the discounting of future cash flows. Obviously, interest rate exposure in financing commercial property will have an impact on the net present value of the cash flow over the life of the investment. The major component of the discount rate applied in this method will be prevailing or estimated interest rates.

Whenever debt financing is used in transacting commercial property, the direction of interest rates will impact leverage, or more commonly referred to as the return and risk of the transaction. Positive leverage occurs when a commercial property’s return exceeds the cost of debt, thereby increasing the return to the investor. Thus, in a low interest rate environment, the prospects for positive leverage reduce the overall risk of the transaction while enhancing the return potential. Conversely, negative leverage, where debt costs exceed the return on the property, is most common during periods of high interest rates and depressed rental rates.

The return on investment becomes foremost when developing property for commercial use. Unlike the purchase or sale of existing commercial property, where comparative pricing and interest rates are used to determine capitalization rates, construction and development of commercial property requires extensive use of net present value (NPV) and internal rate of return (IRR) calculations to determine the viability and return potential of the project in question. Interest rates are a key component in discounting projected cash flows on a commercial project, as well as the consistency of projected cash flows. Other financial variables come into play when utilizing the NPV or IRR methods in developing commercial property. The projected discounted cash flows must reflect expenses such as depreciation and taxes, both of which impact the return potential of the project and the underlying discount rate applied in calculating the viability of each project. These same financial variables are a factor under the NOI and ATCF methods when evaluating a purchase/sale on an existing commercial property. The only difference being the cost and nominal cash flows are known and not projected, as is the case in a newly constructed property.

As stated earlier, interest rates appear to have a direct impact on commercial real estate activity. In reality, however, their direct impact involves financing of commercial real estate, not creating supply or demand.

The keys to supply and demand within the commercial real estate market relate to pure economic fundamentals. Since 2003, we have witnessed resurgence in commercial real estate activity, especially within commercial office space. Companies acquired more office space in the fourth quarter of 2004 than any quarter in the past four years. Vacancy rates have decreased significantly, stabilizing rents and confirming the sector is finally in recovery. The basis for the turn around: firms are continuing to hire workers or are preparing to create more jobs. While this may appear elementary, the mere prospect of employment growth has a powerfully direct and positive correlation to commercial real estate activity. According to research firms, absorption and vacancy rates are important factors that impact commercial office space demand and show positive trends. Absorption, the net change in total occupied space, was 20 million square feet in the fourth quarter of 2004—the most in four years. For the entire year of 2004, absorption totaled 40.8 million square feet, compared with a negative 8.5 million square feet in 2003 and a negative 35.8 million square feet in 2002. Vacancy rates have decreased nearly 1 percent from its peak of 16.9 percent in the fourth quarter of 2003.

The real estate industry weathered the recent downturn far better than it managed the constraint of the late 1980s and early 1990s, which fed the savings and loan crisis and led the United States economy into recession. Despite similar vacancies and an unprecedented period of negative absorption that lasted nearly three years, the combination of low interest rates, better management and a lack of speculative building has prevented a rash of foreclosures. Developers and financiers scaled back new construction soon after the stock market decline in late 2000, and the 29.1 million square feet of commercial space completed in 2004 was the least since 1996.

Real estate consulting firms project about 34 million square feet of new commercial office buildings in 2005, up slightly from 2004 but well below the peak of 137 million square feet added in 1999. More importantly, speculative office space building is being held to a minimum, as over 70 percent of the projected new space in 2005 is pre-leased. With vacancy rates running at 16.2 percent, nearly double the rate from the commercial market peak of 2000, rents have come down nearly 20 percent from their high of $25.34 per square foot in the first quarter of 2001.

The next 25 years will witness increasing demand for additional commercial space. According to the Brookings Institution, by 2030, the United States will need 44 percent more built space than existed in 2000. More importantly, about 131 billion square feet of the total needed will be new construction. The basis for this demand—job growth projection and population growth.

Unlike the consumer mortgage market, where interest rates drive the demand for housing activity, interest rates do not create demand within the commercial real estate market. Commercial real estate demand and new construction is positively correlated to overall economic activity and demographic movement.