White Coat Investor – How Interest Rate Changes Impact Real Estate Valuations

White Coat Investor – How Interest Rate Changes Impact Real Estate Valuations

[Editor’s Note: This is posted as a guest post on The White Coat Investor Blog by Mascia Development LLC. This article shows the important implications for those interested in investing either directly in properties in their home town, or indirectly via a syndication company. We have no financial relationship.]

Introduction

Rising interest rates are the talk of Wall Street and Main Street now that the President of the Federal Reserve Bank of Dallas has predicted the central bank will raise interest rates in 2015. Real estate markets across the US are already reacting to this rising interest rate chatter, according to a national assessment of commercial real estate investments in all 50-states.

My firm assessed commercial property value and prospects in all fifty states, looking for US cities with the best opportunities for long-term, stable growth. Our valuation criterion assessed multiple factors, including diversity and strength of employer base, 12-year population growth trends and current cash returns on investment grade real estate. We did this while looking for the best investment opportunities for our real estate fund. The analysis also highlighted the worst commercial real estate markets for investors based on the current bubble-like pricing and un-sustainable rental growth projections.

“Global Entry” Primary Cities vs Secondary and Tertiary City Investment Returns

Our study concluded that secondary and tertiary real estate markets, like Nashville-Davidson, TN and Albuquerque, NM, are better positioned to survive future interest rate hikes while primary global gateway markets like New York City and San Francisco, will get hit hardest. Secondary and tertiary real estate markets have had consistently low demand throughout this recover,y keeping cash on cash returns relatively high. The real estate fundamentals remain strong due to high population percentage growth and low addition to supply of new commercial real estate inventory. This should lead to continued higher real estate returns relative to primary markets.

Global gateway cities are now oversaturated with international investors. In addition, yield-starved domestic investors have already driven up property values to unsustainable levels in these cities, creating the most risk for steep declines in value once interest rates rise. Many of the largest real estate inventors share the misconception that a global gateway market is the safer bet for investments, but the statistics show the opposite is true, right now. Secondary and tertiary markets are better bets for investors at these price levels, with their increasing stability and stable growth.

Sensitivity to Rising Interest Rates

Our report also conducted a sensitivity analysis to test how a 200-basis point expansion in cap rates (which will likely come as interest rates increase) would impact commercial real estate investments in all 20 markets. It found that an expansion in cap rates in most of the US’s largest cities, from 4% to 6%, would ignite a 33.33% loss in value for investors. This means that for investors to just break even, rents would need to grow by 50%, an unrealistic expectation given the high rent and average income levels in many of these locations.

As a comparison a similar cap rate hike from 8% to 10% in secondary and tertiary US markets would ignite only a 20% drop in property values, which would only require 25% rent growth to break even. This illustrates the relative safety in secondary and tertiary markets, all other things being equal.

Most Overvalued and Undervalued Markets

Here is a look at the Top-10 best and worst markets identified in this real estate investment analysis.

Top-10 Undervalued Markets for Real Estate

  • Albuquerque, New Mexico
  • Anchorage, Alaska
  • Chandler City/Mesa, Arizona
  • Columbus, Ohio
  • Joliet/Aurora, Illinois
  • Kansas City/Overland Park, Missouri/Kansas
  • Lincoln, Nebraska
  • Madison, Wisconsin
  • Nashville-Davidson, Tennessee
  • Tulsa/Broken Arrow, Oklahoma

Top-10 Overvalued Markets for Real Estate

  • Austin, Texas
  • Boston, Massachusetts
  • Dallas, Texas
  • Houston, Texas
  • Los Angeles, California
  • Miami, Florida
  • New York, New York
  • San Diego, California
  • San Francisco, California
  • Washington, DC

Ranking Cities by Cap Rate

Our report also calculated real estate cap rates (aka current unlevered return, what a property’s cash on cash return would be if it were completely paid off) for these markets in the first six months of 2014 in the retail, office, and multifamily real estate sectors. Cap rates for the Top-10 markets were 8.04%, compared to the Top-10 worst average, which calculate to 4.64%. So if the worst 10 markets were a bond they would be paying a coupon of 4.64% annually and the best 10 would pay 8.04% with less sensitivity to interest rate risk. Individual market breakdowns are below.

Best Cap Rate Markets

  • Nashville, TN: 7.27%
  • Chandler City/Mesa, AZ: 7.48%
  • Joliet/Aurora, IL: 7.73%
  • Lincoln, NE: 8.12%
  • Anchorage, AK: 8.18%
  • Tulsa/Broken Arrow, OK: 8.20%
  • Madison, WI: 8.25%
  • Albuquerque, NM: 8.26%
  • Kansas City, MO: 8.37%
  • Columbus, OH: 8.52%
  • Best 10 Average: 8.04%

Worst Cap Rate Markets

  • New York, NY 3.67%
  • San Francisco, CA: 3.97%
  • Los Angeles, CA: 4.26%
  • San Diego, CA: 4.50%
  • Boston, MA: 4.66%
  • Austin, TX: 4.85%
  • Washington, DC: 4.88%
  • Miami, FL: 4.94%
  • Houston, TX: 5.14%
  • Dallas, TX: 5.53%
  • Worst 10 Average: 4.64%

 

What do you think? Where are your real estate investments? Did you pay attention to valuations when you bought them? How would this information change the way you invest in real estate? Do you agree with the author’s rankings? Why or why not?

Written by Mark Mascia

Mark Mascia

Mark has the overall responsibility for managing the investment and operating activities of Mascia Development.

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