FEATURE ARTICLE, JUNE 2004

THE UPSIDE OF RISING INTEREST RATES
Midwest lending surges as markets bottom out.
David Hall and Rick Percifield

The commercial real estate market across the Midwest has seen a resurgence in financing demand as property owners, developers and investors buy into an economic recovery expected to lift the region’s major real estate sectors out of the cyclical lows of the past few years.

With interest rates poised to move higher, lenders in turn have seen a surge in deal volume during the first 5 months of the year. Meanwhile, borrowers are benefiting from strong competition across the Midwest and increasingly turning to solutions like rate-lock financing to secure historically low interest rates and hedge against expectations of rising rates in the months ahead.

“The longer-term outlook for interest rates is generally upward, and the days of sub-5 percent mortgages are long gone,” says Mark Vitner, Wachovia senior economist. He expects the benchmark 10-year Treasury to reach 5 percent at year-end.

Players in the Midwest’s commercial real estate sector are positioning themselves ahead of the anticipated recovery, actively trading properties in the office, multifamily, retail and industrial sectors.

Office properties in particular are aggressively being repositioned despite the lingering effects of the downturn. The recent sale of the Sears Tower was a bellwether deal, signaling intense interest in the downtown Chicago office market. Although the market remains slightly overbuilt, lenders have seen strong financing activity from players trading office properties in Chicago and other major Midwest cities.

On a smaller scale, acquisitions also have been accelerating in the retail and apartment sectors at relatively aggressive cap rates. It’s a great time to be a seller right now. Buildings are trading, and there’s a lot of capital chasing too few deals.

In Chicago, strong demand for condominiums has led the way for an anticipated rebound in the multifamily sector. Rents have held steady as the apartment market bottoms out, and developers are discovering niche opportunities that play into a recovery for the sector.

Although nearly one in three of the nation’s largest metropolitan areas will continue to see declining revenues in the multifamily sector, vacancy rates nationally are expected to peak and the industry overall should post a nominal increase in revenues this year, followed by 3 percent growth in 2005.

The availability of relatively cheap debt is promoting supply growth despite lingering weak fundamentals, and interest rate hikes later this year should help by curbing both new development and homeownership. Borrowers also continue to benefit from increased competition among lenders in this sector.

On the retail front, Detroit and Chicago posted among the highest CMBS delinquencies among major cities nationwide compared to the national average. Overall, the Chicagoland retail market is relatively stable, with vacancies near the midpoint of traditional cyclical highs and lows for the city.

In Minneapolis, the retail strip and community center markets may see a pop in vacancy due to recent supply growth. Most recent development has been in lifestyle centers and freestanding, big box projects.

Still, investor appetite for strip centers remains strong, and power centers have lived up to their name in performance in CMBS pools, according to a recent Wachovia Securities analysis.

In the hotel sector, a recovery is building momentum as business travelers return to the skies, driving benchmark revenue per available room up by around 5 percent nationwide this year.

In addition to the looming interest rate hikes, property owners and investors need to factor in an upward drift in cap rates. Since 2000, declining interest and cap rates offset some of the worst industry fundamentals since the early 1990s, enabling real estate and real estate securities to post outstanding performances despite the downturn.

Strong property valuations and lower debt costs insulated the sector, boosting commercial mortgage performance both for CMBS investors and on-balance sheet investors like banks, REITs and insurance companies. Loan delinquencies this downturn have remained at a fraction of early 1990s levels.

But with improving property fundamentals and rising interest rates on the horizon, borrowers should shift their focus toward the prospect of increased borrowing and cap rates and the resulting impact on property values.

Wachovia analysts believe cap rate increases likely will not erode property valuations across the board because of large risk premiums built into current cap rates. Although cap rates have fallen steadily since 2000, interest rates have fallen further. This has cushioned risk premiums for all property types.

But there is potential for price depreciation in some sectors and markets. This potential is greatest in the suburban office market, which is a sub-sector that has been slow to regain its footing in the early stages of this cyclical recovery.

For investors, this shift to improving fundamentals and rising rates means that total return performance will be driven by improving property cash flows.

The shifting tide in the capital markets also is expected to put additional pressure on property valuations as money that had been diverted from equities returns to that market or seeks yields elsewhere. To some institutional investors, the commercial real estate sector simply may seem a bit too rich.

Most major players are not too steeply leveraged and have a strong enough cash position to cope with rising cap rates. But some players will be pinched by rising rates, and some traditional and non-traditional players are poised to take advantage of the emerging paradigm shift.

The good news at this point is that there are no signs of distress as the Midwest nears the end of the cyclical downturn. Although higher rates are on the horizon, they reflect the upward pressures of job creation, reduced vacancies and other benefits to the sector from an economic recovery.

David Hall is a director and Rick Percifield is a senior vice president with Wachovia Real Estate Capital Markets.

©2004 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.