By: David Winzelberg August 29, 2014

While Long Island brokers have enjoyed the real estate market’s recovery from the depths of the Great Recession, some are warning that a forecast rise in interest rates could have a chilling effect on the reheated industry.Analysts say the Federal Reserve is on target to raise interest rates next spring and may push them past 5 percent, a number not seen since before the economic downturn began six years ago.

Though a sizeable increase in interest rates would put the brakes on any real estate market, a rate hike would be more harmful to certain overvalued areas – including gateway markets like the New York metro area, according to a new report from Manhattan-based Mascia Development.

Low interest rates have been over-inflating prices and shrinking capitalization rates for some time, brokers say, and the situation is particularly acute in the New York market. In fact, the New York metro area leads the nation with the worst (lowest) cap rates out of all metro areas in the country, the Mascia report found.

Looking at cap rates of retail, office and multifamily property sales for the first six months of 2014, New York clocked in with an average of 3.67 percent. By comparison, undervalued secondary and tertiary markets have been delivering much better returns. For example, cap rates on commercial property sales in Kansas City, Mo., averaged 8.37 percent for the first half of the year, and Columbus, Ohio, had an average cap rate of 8.52 percent, Mascia reported. On Long Island, the average cap rate for the first half of 2014 was 5.76 percent, according to Mascia, much better than New York City but “still very risky” compared to undervalued markets around the country.

The dearth of relatively safe institutional investments with decent yields has contributed to an increased demand for investment opportunities in real estate, especially for triple-net-leased properties involving top-credit tenants such as banks and strong national retailers. And low interest rates have only added fuel to that fire. “What we are witnessing is not the intrinsic value of real estate rising, but the rising tide of available cheap money that’s inflating prices,” said Ron Kleinberg of Tri-State Properties in Dix Hills.The result has been a swing towards a sellers’ market, Kleinberg added, where the lack of alternative financial investments has emboldened property owners to ask for higher prices.

Corey Gluckstal, who heads the investment sales division for Sabre Real Estate Group in Garden City, said the influx of foreign money – especially from Russia and China – has further reduced returns and pumped up prices on commercial real estate in gateway markets like New York. “They’ll take 3 or 4 percent,” Gluckstal said. “For them, it’s preservation. They have nowhere to put their money back home.” Meanwhile, brokers are waiting for the other shoe to drop.

“The elephant in the room is what happens when rates rise and loans mature?” Kleinberg asks. Mascia Development principal Mark Mascia said a significant rise in rates – say, from 4 percent to 6 percent – would be devastating, triggering a 33 percent loss in commercial property values here and forcing rents to skyrocket to make up the difference. “Rents could go as much as 50 percent higher just for landlords to break even,” Mascia said.

While larger property owners like real estate investment trusts may be able to weather a substantial rate hike, highly leveraged smaller investors are likely to suffer the most. “If and when interest rates rise, there’ll be an equity squeeze,” Gluckstal said. “And it all rolls downhill.”