Shopping Centers Today

JUL 2015

Shopping Centers Today is the news magazine of the International Council of Shopping Centers (ICSC)

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rates will rise this year. Then too, his- torically, when interest rates rise, cap rates follow. But here again, not every- one is sure that will happen in such an orderly fashion if rates do go up this year. And third, if interest rates do rise, the effect on the retail sector is open to debate as well. In short, much like the Fed's prediction for raising rates — hardly etched in stone — the potential effects of such a rate move- ment are guesswork, at best. "It's not a foregone conclusion that rates will go up," said Adam Petriella, ex- ecutive vice president for capital markets at Coldwell Banker Commercial Alli- ance, in New York City. "There are a lot of subcurrents in the market that could preclude or prevent a rate hike. The 'normal' cycles are not normal." Under the old normal, interest rates rise, cap rates follow, and prices decline. In this global economy awash with liquidity and structural issues, however, low rates may prevail, Petriella says. "The markets are as diverse as the needs of the buyers themselves. So, for instance, a foreign buyer or family office preserving capital is not necessarily as sensitive to rates as, say, a general partner or merchant de- veloper for whom low rates help unlock creativity and value." But Brandon Harrington, a senior vice president at Walker & Dunlop, in Phoenix, thinks interest rates will rise before the end of the year. He points out, however, that those are short-term interest rates. Long-term interest rates are typically priced off the U.S. 10-year Treasury, which currently offers a higher yield than similar bonds in the U.K., Germany and Japan, making the invest- ment very attractive to global investors. "Even if interest rates go up, because the rates for commercial mortgages are typically priced off the 10-year Trea- sury and there is a maximum amount of capital flowing to the Treasuries, we see this putting downward pressure on long-term rates," said Harrington. And then there is the additional factor of in- vestment demand for commercial real estate. "The normal reaction is that cap rates will rise if interest rates climb, but there is so much capital on the sidelines, the competition for product is intense, with more buyers than quality proper- ties on the market," said Harrington. "There will be a lot of pressure for cap rates to stay low." Cap rates in the first quarter contin- ued to fall across all property types, ac- cording to Real Capital Analytics. Retail sector cap rates fell by 40 basis points to 6.4 percent, slipping below the previous low-water mark of 6.5 percent in 2007. All this varies by property type and loca- tion. Real Capital Analytics notes that cap rates for smaller markets averaged 7 percent, while the average cap rate at the six biggest markets fell to 5.6 percent. If interest rates rise gradually, as many analysts expect, cap rates may not face tremendous upward pressure in the near term. "So what if interest rates go up 50 basis points," said Kris Cooper, a managing director in the JLL Capital Markets Group, in Atlanta. "We are at historic lows. We are seeing lenders be- come more aggressive in terms of loan- to-value and interest-only periods. We are spoiled by the fact that interest rates have been low for so long. Even if in- terest rates rise by 50 basis points, that's still one heck of an interest rate when you look at it long term over the past years." Things change when interest rates rise, Cooper says. "But most buy- ers don't look at it on a day one analy- sis; they are going to look at three-, five- or seven-year hold periods. Over the life of the loan, the fact that interest rates were x versus y at the time they acquired property is marginal. Even looking at the internal rate of return that is lever- aged, it is just not that huge an impact. If there was a dramatic 300-basis-point rise in interest rates, yes, but there is no rationale in the economy to cause that much of an increase." In May 2013 the Fed announced that it would taper back its bond-buying program — or quantitative easing. This caused the yield on the 10-year Treasury to spike, upsetting markets in an event that has since been dubbed the "taper tantrum." Among the victims in the turmoil were REITs, which analysts view as being as interest-rate-sensitive. Depending on how the Fed handles the interest-rate increase, the taper tantrum could be seen as a preview of what is go- ing to happen, says Lawrence P. Casey, president and COO of Donahue Schriber, Costa Mesa, Calif. "The Trea- suries went up 100 basis points over sev- eral months, short-term rates increased on the forward curve, and then REIT shares took a bit of a hit," said Casey. Rather than by earnings per share, REITs are valued based on funds from operations, which include interest ex- pense, says Mark Bratt, a senior man- aging director at CBRE, in New York City. So if debt maturities are coming due with a low interest rate, and the new interest rate will be higher, that would affect FFO. Not everything is this cut-and-dried, however. "One of the reasons FFO has gone up is that inter- est expense has come down, but if inter- est rates go up, it will negatively impact the REITs from an interest-expense perspective," said Bratt. "If interest J u l y 2 0 1 5 / S C T 39 "If interest rates are going up, that's because the economy is stronger, then retailers do well. Retailer sales will improve, and rents will increase."

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