Capitalization Rates Continue to Decline

Despite the fact that fundamentals in the U.S. real estate market were deteriorating throughout 2002 and 2003, capitalization rates dropped significantly in all property categories as prices continued to rise. This was primarily due to the very low level of mortgage interest rates that permitted investors to earn relatively high cash-on-cash returns from leveraged real estate. It also reflected investors’ optimism that an economic recovery would eventually improve the fundamentals in the real estate market.

It would now appear that the real estate market may have hit bottom in the third quarter of 2003, and occupancy rates and rental rates have at least stabilized in most markets around the country, with signs of improvement appearing more frequently. But the flood of money into the U.S. real estate market continues to drive capitalization rates and prices to levels that appear to be unsustainable in the long run.

top

The Office Market:

Final statistics for 2003 are now generally available and they show that the office vacancy rate in the U.S. was virtually unchanged last year. While the vacancy rate remained at approximately 16.5% nationwide, 2003 was the first year since 2000 in which the office market showed positive absorption. In fact, each of the final three quarters of the year showed occupancy growth – the first time that has happened since 2000 – and total absorption for the year slightly exceeded 27 million square feet. This was a major turnaround from the negative absorption of 38 million square feet in 2002.

As absorption turned positive, the downtrend in office rents that had been underway since 2000 came to a halt. For the entire year 2003, downtown office rents declined 4% and suburban rents fell by just over 1% - declines that were dramatically lower than in the previous year. However, rents not only stabilized but began to show increases during the final quarter of the year. Another positive sign was that the amount of sublease space that is overhanging the market showed a marked decline. Sublease space still represents about 15% of total vacant space currently available, but there are many fewer sub-lessors adding to the amount of this space on the market.

Another positive for the office market is that new construction has been in a consistent decline since 2000. In 2001 over 135 million square feet of new office space reached the market; last year there were only 59 million square feet, and projections indicate that in 2004 the total will be even lower. Speculative construction is virtually unknown around the country, with practically all new construction involving build-to-suit projects.

Through much of the recessionary period in the United States, a great deal of the money that flowed into real estate was looking for a bond-substitute type of investment. Therefore, properties on long-term leases to credit quality tenants were the most sought after, and capitalization rates on this type of investment fell sharply. For most of the period from 2001 to mid-year 2003, properties that had any credit or leasing risk, or were located in secondary markets, traded at much lower prices and at much higher cap rates. With the economic recovery becoming more evident in mid-2003, investors became more willing to assume some degree of risk, and capitalization rates began to decline precipitously on properties that would previously have been avoided. As a result, there is a growing risk that cap rates throughout the office sector have reached levels that cannot be sustained once interest rates begin rising again in the credit markets.

top