Most real estate pros today are actively monitoring the current sale market, either in disbelief, or starting to think about selling into an “up” market.  At the same time, buyers are cringing from “sticker shock”.  Their hope is that there will soon be a “bursting of the pricing bubble”.  In the language of institutional investors, is the present pricing bubble “sustainable”?

A review of Table 1 on aggregate sales volume over the past 5 years indicates that there is indeed a continuing sale trend in terms of total sale volume.  For each of the past 2 years, the prior year’s sale volume exceeded the earlier year by more than 50% (+63% from 2001 to 2002; and 55% form 2002 to 2003).  Prospects are that trend will continue.

Table 2 indicates that the average sale price/property is (and has been) in the $60-70M category.  Only in year 200 did this average figure well exceed the $60-$70M norm.  This is attributable to product mix and more limited sale activity as market observers were trying to understand macro market trends at the time (economic bubble was starting to “pop”).

While average prices were remaining fairly stable, Table 3 indicates a sharp average price increase.  For 2002, average price/SF equate to $275/SF; for 2003 it was $298/SF.  So far in 2004, it is at $315/SF+-.  Partially, this is attributable to property “mix” (Class A versus number of Class B sales).   More importantly, however, it appears to be driven by declining cap rates.

Table 4 shows a sharp decline is cap/yield rates post 2001.  Clearly this was driven largely by the Fed’s interest rate policy (post 9/11 cuts to stabilize the economy).  Average cap rates have declined from 8.8% in 2002 to just above 8% today.  Currently, “average” cap rates appear to be steady from 2002, but averages can be deceiving.   As any buyer will tell you, Class A projects have cap rates that continue to decline.  They are now commonly in the 6-7% range for quality properties.  When contrasted to the “average” (8.1%), the significance of the gap (Class A versus Class B/C) is apparent.  In addition, the present figures do not yet include several “brewing” deals that will push even the average figures lower.

Given these recent, local trends, and the widely held view that interest rates will climb in the near future, what is a buyer to do?  Should they wait for cap/yield rates to rise (lowering value)? Should they “bite the bullet” and buy anyway, even with the prospect that values may decline post closing?  Are cap/yield rates based more on underlying interest rates, or are they more driven by supply/demand factors?  In other words, are the present cap/yield rates “sustainable”?

Obviously, there is no easy answer.  Further, as usual when it comes to real estate, “it depends” (ever heard that statement?).  For most submarkets, the answer is that current low rates are NOT sustainable.  As it relates to Downtown DC office buildings, the answer is that they ARE sustainable.  Why?

Interviews with investors with experience in other markets are enlightening on the subject.  (Funny:  Once again, we seem to learn more from outsiders who are not “wrapped up” in local details as much as we are).  DC is expected to continue to have sustainable cap/yield rates in their view.  The reasons are as follows:

1. Our traditional “slow growth” as compared to other areas is, in this case, a benefit, not a problem.  It will allow investors to constantly monitor economic progress here more so than other submarkets.  Other markets are more uneven.  This complicates the projection process and increases risk.  Thus, our general stability will continue to attract buyers, especially if world events deteriorate.
2. Land supply constraint will continue to press values higher and faster than rents will increase.  Thus, cap/yield rates must decline as a result.
3. Replacements costs will also increase.  In addition, and in contrast to many “bubble markets” of the recent past (Boston; SF; Denver; etc), DC replacement costs and sale values rarely diverged by a significant amount.  In more volatile submarkets, large value shifts occurred in this comparison.  This drives investors away, and creates huge value swings (i.e., not sustainable).
4. Weaknesses in other submarkets will continue.  While there is improvement noted in published in many national statistics in the past 30-60 days, that still is insufficient for investors to start buying elsewhere in significant amounts.  We would view this as a low level of either property or portfolio risk spreading.
5. Stock market factors are also improving, but again, this is not expected to siphon dollars away form real estate.
6. The Fed has limited room to increase rates.  Analysts are expecting up to a 50 b.p. increase over the next 12-18 months.  To date, real estate has not seen this increase “passed through” to the buyers as yet.  Real estate has historically been a very “pass through” oriented industry (leases; mortgages).  If that has not occurred as yet, can it be said that cap/yield rates are primarily interest rate driven?

In summary, it would appear that for the first time in recent (last 5 years) memory, cap/yield rates are now more supply/demand (of capital) driven than in many years.  In fact, the only other time in recent memory where such a similar shift occurred (i.e, cap/yield rates were not tied directly to underlying interest rates) was in the early 1990’s recession.  Then, investors didn’t care what financing costs were (assuming financing was available in the first place!).  A property was either vacant or occupied, and pricing was based more on a $/SF (cost) analysis than yield driven.

The good news is pricing and cap/yield rates appear to be “sustainable” for the near-tem.  RCDH would NOT expect “buy rates” to increase in the same proportion as underlying interest rates as they more upward in coming months.  The best news is that real estate really has shown it has the capacity to perform at exceptional levels.  This, by itself, will continue to attract more institutional capital on a long-term basis, which will further help create “sustainability”.

Dennis Duffy, MAI

Principal, RCDH & Co.

Published in DCBIA, June 2004.  Pipeline, Washington, DC: DCBIA.

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