Real Estate Gets Jitters From Rates By SHELLY GARCIA Senior Reporter A bump in commercial mortgage interest rates that’s occurred over the past few weeks is fueling speculation that the real estate market could be in for some long overdue right-sizing. The increase, about 70 basis points, still leaves interest rates for commercial mortgages near their 40-year lows, but many say the rise so far is just the beginning, and if rates continue to climb as many believe they will buyers will start to walk away from the rich deals that have characterized the real estate market until now. “People are really stretching to make the numbers work,” said Brian Forster, executive vice president at TOLD Partners in Woodland Hills, “and when there’s a slight increase in interest rates, you’ll see a lot of deals fall out of escrow.” Over the past two years prices for San Fernando Valley properties, as with others in the L.A. area, have escalated to what many call “crazy” levels, in some cases as high as $250 a square foot. But buyers were plentiful in spite of the high prices because interest rates were so low and the potential returns from real estate far surpassed what the recent stock market has recently offered. Still, brokers like Forster and others point out that as prices have escalated, buyers have stretched their debt liability to the maximum, and even a small rise in interest rates can push them over the threshold. “The minute the economy starts cranking and they bump interest rates, you have a lot of people who are going to be in trouble,” said Rick Pearson, a principal with CRESA Partners in Woodland Hills. “Two years ago if you paid $150 (a square foot) you were paying too much. Now if you don’t want to pay $250 you don’t even get in the game. It’s been a constant increase.” In the past three weeks, the 10-year treasury rate has risen to about 4.5 percent from about 3.8 percent. Smaller buildings of under $5 million, typically financed by SBA loans, are triggered by other yardsticks. But loans for larger buildings are tied to the 10-year treasury rate along with the prime rate. Last week the Federal Reserve Bank decided to leave rates at their current levels, but an employment report, which was released after presstime, was expected to paint a picture of a strengthening economy, and speculation was ripe that if the Fed did see significant signs that a turnaround was underway, it would raise rates sooner rather than later. “Sellers expectations are going to have to change considerably,” said Trevor Belden, a partner at Lee & Associates North. “I think interest rates will continue to rise, and that means buyers will stop buying 7 and 8 caps for office because the bottom line return is going to be so minimal.” (The real estate community measures property values in so-called cap rates, a multiple of the net operating income of a property.) Rethinking ahead? Indeed, it might not be long before the 10-year treasury rate jumps to 6 percent, and when and if that occurs, buyers are likely to rethink the prices they have been willing to pay for properties. In some cases they may find themselves paying more in interest than the returns they are getting from the property. “What happens is people have to re-evaluate their investment horizon and return,” said Bob Safai, a principal with Madison Partners, who specializes in real estate sales. “If they were looking to get a 7 percent (return) and because of interest rates the return gets to 5 percent, they have to figure out if they want to invest in that property.” Industry wisdom has basically said that if a buyer pays dearly for a building, but the costs to buy it the interest on the loan is low, the high price is justified. But as interest rates rise, the cost to service debt grows disproportionately and buyers begin to question the value of the acquisition. “I’ve got some properties for sale at per square foot prices that are really so far up there I shake my head,” said Jerry Scullin, a principal with Delphi Business Properties. “There is going to be a point where people are going to say the prices are too high, I’m going to wait.” Already there are signs that sellers are jumping into the market, hoping to take advantage of what may be a peak in the high price of real estate. “I’ve seen more packages (from sellers) coming through,” said Dave Mgrublian, CEO at Investment Development Services Inc., which also currently has its Westlake North property on the market. “I think sellers realize this is a good time to sell while interest rates are relatively low. Buyers would rather buy now.” All about timing But whether they get in under the wire is anybody’s guess. “The people who bought in the last three to six months of the market are going to get hurt,” said Pearson, conceding that no one knows when the last three to six months will come. “It’s a crapshoot.” Some say the expected drop in pricing is a good thing, and the cycle is long overdue for a correction much like what happened in the stock market earlier in the decade. Indeed as real estate prices have risen, fundamentals long used to gauge the value of a property such as the cost to replace the building in relation to the price to buy it or lease rates and the potential to raise them, have been ignored, much like the stock market of the late 1990s when stock prices bore little relation to a company’s earnings. “These things have to occur when you throw caution to the wind and the fundamentals are thrown out the window and you make decisions based on what your valet told you,” said Safai recollecting the Internet bust. “If you’re making a real estate decision based on interest rates only that is not a prudent decision.” At the same time, real estate acquisitions have been the only active portion of the market, making some brokers more than a little nervous about their earning potential in the near future. If buying activity drops while the leasing portion of the market remains in the doldrums there will be few opportunities for brokers who have relied on sales transactions in the past few years to make a living. Some say that is not likely to happen. Rising interest rates, they reason, would signal a general recovery that would include a pickup in the leasing side of the business. Mgrublian believes that an improving economy would be enough to continue to drive the acquisition market, albeit not at the same price levels. “While interest rates will cool the rise in prices, they’re not going to make things drop like a rock,” he said. “Rising interest rates usually go hand in hand with an improving economy, and if you’re an owner, you’re looking for rising demand for space.” Then too there is some indication that a drop in prices, rather than quash the market for properties, will restore some of the equilibrium that’s been lost in recent years when buyers far outnumbered willing sellers. “I think there will be a few more properties to select from people who were sitting on the fence (about selling),” said Stacy Vierheilig, senior managing director at Charles Dunn Co. “But I think there will be a few less buyers, because they’re getting notched down in their price range.” But the one thing all agree on is that one way or another, real estate prices are headed downward, and buyers along with sellers will have to adjust their expectations where returns are concerned. The only question is when and by how much. “You’re going to see a big drop-off in price,” said Forster. “Everyone’s really watching interest rates right now.”