While the Federal Reserve chose not to raise interest rates at its most recent meeting, the signals were clear that a rate hike will be forthcoming. Should this happen, landlords and investors alike in the Washington, DC area should brace for a change in the investment climate. Leveraged investors who rely heavily on debt may struggle to maintain values with even a modest escalation in interest rates in most of the area’s submarkets. The impact of spending cuts by the federal government on the local contracting industry combined with the new “workplace efficiency” strategies have decreased demand for office space in the market over the last few years. This has resulted in office rent growth slowing significantly in nearly all segments of the market and has created associated market risk.
Notwithstanding the recent volatility in the financial markets and the slowing of the Chinese and other large world economies, the Federal Reserve Board continues to signal that increases in interest rates are likely sooner rather than later. While the real estate financing markets have already priced in what most think will be nominal interest rate increases, these rate changes still pose a risk to investment sales markets in the greater Washington, D.C., area. Without entering into a prolonged period of economic expansion that produces substantial office-using job growth, many of the region’s office markets will not be able to generate enough rent growth for the leveraged investors/buyers to maintain existing cash flow in the event of a robust interest rate increase.
To illustrate the point, an investor who acquires an asset on the following loan conditions:
- 0 percent initial yield
- 0 percent loan-to-value loan
- 50 percent interest rate for 10 years
would need net operating income to increase 6.39 percent to maintain the same initial yield if the interest rate on the loan increased 50 basis points to 5.00 percent. Further, capitalization rates would have to increase 31.9 basis points to absorb the 50 basis point increase in interest rates. If the increase in interest rates were only 25 basis points, the rent growth threshold would need to be only 3.19 percent for that same investor to maintain the initial yield.
Across the entire D.C. metropolitan area, office rents have increased only 0.2 percent per year since the beginning of 2010. Each submarket within the area experienced a different level of growth, with office product in the District of Columbia generating the highest levels, and with the suburban Maryland markets actually declining. Best-in-class/ trophy assets in the District have shown annual rent growth of 3.58 percent per year. Class A asking rents in Northern Virginia have increased only 0.98 percent per year since 2010, and Class A rents in suburban Maryland have decreased 2.04 percent per year. (Comparative rent growth tables can be found in our full report. Click here)
For commercial landlords who have levered their investment properties with floating rate debt, rising interest rates promise to reduce earnings after servicing debt obligations, even when accounting for the built-in annual average increases in leases of 2.5 percent. While the Best-in-class/trophy assets in the downtown market would likely keep close to pace, assets in nearly all of the Northern Virginia and suburban Maryland markets would see some erosion in leveraged cash flows as a result of these increases.
All of this being said, there is not an oversupply of quality office space in any of the D.C. area markets. So, if the local economy can recover, then rent growth will accelerate, thereby reducing the risk associated with interest rate increases.
Although slow rent growth in a rising interest rate environment poses a serious threat to investment sales markets, small incremental increases in the Federal Funds rate are not expected to have much of an effect. The Federal Reserve has been signaling for some time that it will increase interest rates. As a result, most economists believe that the risk of increases has already been priced into the 10-year Treasury. Amidst a great deal of volatility, the yield on the 10-year ended August at 2.21 percent. While predicting where it will end the year is somewhat difficult, it is expected to hover somewhere between 2.25 percent and 2.50 percent. As a result, interest rates should remain around current levels, especially if other factors do not influence the 10-year treasury or interest rates too much.
Nonetheless, it will be important for investors to monitor the 10-year yield curve to see if pressure to increase interest rates grows when the Federal Reserve does push up the Federal Funds rate. Steep inclines could indicate that the spread between the 10-year and interest rates will widen. With the very low rent growth seen in most submarkets in the D.C. area, this could very quickly impact initial capitalization rates and influence the investment sales market.
In the meantime, demand for dollar-denominated assets is expected to remain strong especially given a number of factors: the relative strength of the U.S. economy in comparison to the rest of the world, the floating of the Chinese currency against the dollar and the negative interest rate environment within the Eurozone. The Washington, D.C., area should continue to attract this overseas capital, especially for Core assets in the downtown market. The demand for this product will continue to keep capitalization rates low — with preservation of capital being a primary objective for many of these investors.
Because of the low levels of return the offshore investors are willing to accept, national and regional domestic investors will continue to find acquiring core assets challenging, but should match up well for attractive Core Plus and Value-Add opportunities both downtown and within the close-in suburbs. In spite of the long recovery period from both Sequestration and BRAC, renewed focus on cybersecurity matters may accelerate growth, albeit modest, in the near term, especially in Northern Virginia. Indicators are that procurement spending may increase in 2016 over 2014 and 2015 levels, although decisions made on Capitol Hill may either accelerate or stall this money’s returning to Northern Virginia. Either outcome is just as likely. With that said, even under Sequestration, contract spending should increase above 2015 levels in 2017.
Investment sale activity in suburban Maryland is expected to lag behind sales in both the District of Columbia and Northern Virginia markets, because the probability of a market recovery is much lower, and the recovery period is expected to be much longer. However, there are submarkets that continue to have solid leasing fundamentals, especially Bethesda-Chevy Chase, and similarly, there are buildings that have good, stabilized cash flows which may become attractive investment opportunities.
For the complete Washington, D.C., Investment Sales report click here
For more analyses on the Washington, D.C., area, visit our regional market research page.
Robert is Director of Research for Colliers International in the Greater Washington D.C. area, where his team tracks and reports on marketing conditions relevant to both users and owner of commercial real estate. He is Americas Researcher of the Year for 2015. You can contact Rob by email or on Twitter.