When baseball fans turn their caps backwards or inside out it’s a kind of prayer their team can turn its fortunes around. Commercial real estate has a different kind of backward cap, which is also a sign of a losing streak. TheRealLSL explains.
Anxiety over U.S. commercial property has been heightened by the collapse of two banks, one of which – Signature Bank – was an active real estate lender. Building-related debt has been the cause of crises before. Lehman Brothers’ purchase of apartment company Archstone in 2007 was one reason for its eventual bankruptcy.
The problem this time is a key real estate metric called the “cap rate.” Nothing to do with headgear, this rate reflects the yield on a property, comparable with the yield on a bond. The cap rate comes from dividing a property’s net operating income in any given year – money from rent minus associated costs – by the asset’s value. Ideally, and almost always, it’s higher than the rate at which the owner can raise debt to fund their purchase.
For more than 10 years, that gap remained positive even though cap rates were falling in virtually all real estate subsectors, from shopping malls to apartments. That was mostly a consequence of low interest rates. And the spread made it possible for asset prices to keep rising even though rents, a major driver of net operating income, weren’t going up much. As recently as 2020, the spread was as high as three percentage points.
That narrowed suddenly when the U.S. Federal Reserve turned course and started putting interest rates up with unprecedented speed. For the first time since just before the financial crisis, the baseline cost of debt – the 10-year Treasury – is higher than the yield the owner will get on a building – a situation known in the industry as “negative leverage.” When a new investor risks getting a yield that’s less than the cost of debt, the obvious thing is for them to demand a steep price cut.
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