Exactly 10 years ago, the global capital markets were teetering on the edge of disaster when all of a sudden, the subprime bubble finally burst. In September 2008, the bottom fell out, claiming Lehman Brothers as its first of many victims. In the period of expansion leading up to this event, the local economy grew and diversified, leaving behind the days when Denver was known exclusively as an energy-dependent city. As coastal capital chased yield to the Front Range, prices increased across all product types to levels never seen. Office cap rates for Class A product dipped down into the low 6 percent range – a record at the time for Denver, but a perceived discount to the coastal markets. Record-high prices and low cap rates also are being seen in Denver today. The biggest fundamental difference between the prior cycle and today’s market is the cost of debt.
The 10-year Treasury, a common benchmark for interest rate coupons in the commercial real estate world, reached a peak of 5.23 percent in June 2006. With interest rate coupons on long-term debt from life insurance companies and conduit (commercial mortgage-backed securities) lenders in the 5 to 7 percent range, the gap between buyers and sellers started to grow as levered returns began to diminish with a higher cost of debt capital.
Only recently in the current cycle has the idea of a steadily rising interest rate environment become a reality. The Federal Reserve lowered the federal funds rate to near zero at the end of 2008 and kept it there for seven years to help restart the economy. The London Inter-Bank Offering Rate, or Libor as it is commonly known, was less than 0.3 percent from 2010 until the first post-recession Fed rate hike in December 2015. By comparison, Libor peaked at 5.8 percent in September 2007 and currently is just under 2 percent. Coupled with aggressive bank spreads on floating-rate bridge loans, investors were regularly dealing with interest rate coupons in the 2.2 to 2.5 percent range, often on an interest-only basis. With such a wide gap between interest rates and cap rates coupled with a steady rise in rental rates, the Denver office market witnessed significant appreciation over this period.
There currently is a barbell effect with investor demand for office buildings in Denver. There is heavy demand for either new and shiny core office product with stable, creditworthy cashflow streams or for value-add, opportunistic deals that promise ample short-term returns through a change in management and/or physical rehabilitation. Everything in between – what we consider “core-plus” – has seen thinner bid lists and investors who are requiring higher yield since these “commodity” properties lack significant upside and are fundamentally lacking when compared to core offerings.
The competition for core office deals has attracted deep buyer pools including several foreign capital sources looking to place money in Denver. While cap rates for these deals, which have dipped below 5 percent in certain cases, seem incredibly tight, they still are relatively high when compared to domestic yields in many countries in Asia and Europe. The increase in interest rates likely will impact this buyer profile the least since they are less dependent on debt and typically seek conservative leverage if at all.
In fact, some foreign capital sources, specifically from countries like South Korea and Japan, are deploying debt in the United States commercial real estate market with higher returns than traditional equity investments. Life insurance companies and pension funds from the Pacific Rim are finding more abundant opportunities by offering attractive senior bridge, preferred equity and mezzanine loan options to the U.S. commercial real estate market.
Armed with cheaper capital than was previously available, debt funds have emerged as a formidable competitor to domestic banks with the ability to compress pricing and offer flexibility where the banks cannot due to regulations.
Opportunistic investors in today’s office market must get creative to find returns. With tightening vacancy rates metrowide and soaring pricing expectations, it is hard to buy purely on basis or price per square foot. Real estate operators have created value in complete repositioning/rebranding efforts including extensive lobby and amenity upgrades and, in some cases, even re-skinning the exterior of the building. Debt funds, as mentioned before, have become a strong alternative to banks and allow value-add buyers to load their capital expenditures into their loan structure where, in some cases, 100 percent of the capital costs are funded out of debt as opposed to equity. In this constantly evolving space, debt funds are competing against each other by offering flexibility in prepayment penalty periods (sometimes as little as six months) and in step-down pricing whereby the spread may start higher for a risky deal and will adjust upon meeting specific coverage or debt yield requirements. While there is significant demand for new product, returns on ground-up construction have diminished due to a combination of rising construction costs and the upward movement in Libor.
Each year that goes by, we get deeper into this current cycle of economic expansion, and the crystal ball becomes less and less clear. Yet, the case for an optimistic outlook can be made since current interest rate benchmarks still are significantly below the levels seen in the last cycle and regulations in the banking and CMBS arenas have kept lending standards in check as a precautionary measure.