ZTed - How Interest Rate Changes and Valuations

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May Impact Various Markets,



Rising interest rates are the talk of Wall Street and Main Street now that the President of the Federal Reserve Bank of Dallas has predicted the central bank will raise interest rates in 2015. Real estate markets across the US are already reacting to this rising interest rate chatter, according to a national assessment of commercial real estate investments in all 50-states.

“Global Entry” Primary Cities vs Secondary and Tertiary City Investment Returns

Our study concluded that secondary and tertiary real estate markets, like Nashville-Davidson, TN and Albuquerque, NM, are better positioned to survive future interest rate hikes while primary global gateway markets like New York City and San Francisco, will get hit hardest. Secondary and tertiary real estate markets have had consistently low demand throughout this recover,y keeping cash on cash returns relatively high. The real estate fundamentals remain strong due to high population percentage growth and low addition to supply of new commercial real estate inventory. This should lead to continued higher real estate returns relative to primary markets.

Global gateway cities are now oversaturated with international investors. In addition, yield-starved domestic investors have already driven up property values to unsustainable levels in these cities, creating the most risk for steep declines in value once interest rates rise. Many of the largest real estate inventors share the misconception that a global gateway market is the safer bet for investments, but the statistics show the opposite is true, right now. Secondary and tertiary markets are better bets for investors at these price levels, with their increasing stability and stable growth.

Sensitivity to Rising Interest Rates

Our report also conducted a sensitivity analysis to test how a 200-basis point expansion in cap rates (which will likely come as interest rates increase) would impact commercial real estate investments in all 20 markets. It found that an expansion in cap rates in most of the US’s largest cities, from 4% to 6%, would ignite a 33.33% loss in value for investors. This means that for investors to just break even, rents would need to grow by 50%, an unrealistic expectation given the high rent and average income levels in many of these locations.

As a comparison a similar cap rate hike from 8% to 10% in secondary and tertiary US markets would ignite only a 20% drop in property values, which would only require 25% rent growth to break even. This illustrates the relative safety in secondary and tertiary markets, all other things being equal.
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Most Overvalued and Undervalued Markets

Here is a look at the Top-10 best and worst markets identified in this real estate investment analysis.

Top-10 Undervalued Markets for Real Estate
Albuquerque, New Mexico
Anchorage, Alaska
Chandler City/Mesa, Arizona
Columbus, Ohio
Joliet/Aurora, Illinois
Kansas City/Overland Park, Missouri/Kansas
Lincoln, Nebraska
Madison, Wisconsin
Nashville-Davidson, Tennessee
Tulsa/Broken Arrow, Oklahoma

Top-10 Overvalued Markets for Real Estate
Austin, Texas
Boston, Massachusetts
Dallas, Texas
Houston, Texas
Los Angeles, California
Miami, Florida
New York, New York
San Diego, California
San Francisco, California
Washington, DC
Ranking Cities by Cap Rate

Our report also calculated real estate cap rates (aka current unlevered return, what a property’s cash on cash return would be if it were completely paid off) for these markets in the first six months of 2014 in the retail, office, and multifamily real estate sectors. Cap rates for the Top-10 markets were 8.04%, compared to the Top-10 worst average, which calculate to 4.64%. So if the worst 10 markets were a bond they would be paying a coupon of 4.64% annually and the best 10 would pay 8.04% with less sensitivity to interest rate risk. Individual market breakdowns are below.

Best Cap Rate Markets
Nashville, TN: 7.27%
Chandler City/Mesa, AZ: 7.48%
Joliet/Aurora, IL: 7.73%
Lincoln, NE: 8.12%
Anchorage, AK: 8.18%
Tulsa/Broken Arrow, OK: 8.20%
Madison, WI: 8.25%
Albuquerque, NM: 8.26%
Kansas City, MO: 8.37%
Columbus, OH: 8.52%
Best 10 Average: 8.04%

Worst Cap Rate Markets
New York, NY 3.67%
San Francisco, CA: 3.97%
Los Angeles, CA: 4.26%
San Diego, CA: 4.50%
Boston, MA: 4.66%
Austin, TX: 4.85%
Washington, DC: 4.88%
Miami, FL: 4.94%
Houston, TX: 5.14%
Dallas, TX: 5.53%
Worst 10 Average: 4.64%