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    Thursday, May 15, 2008


    By Catherine Curan
    The softening commercial property market contains a small silver lining for investors: Returns on investment are on the rise. Cap rates for Manhattan office properties, the annual rental income from a building divided by its purchase price, plummeted dramatically over the last six years as the market recovered from the aftermath of Sept. 11 and the economy boomed. Investors were willing to buy commercial property with skimpy returns — such as the record 2006 Istithmar purchase of 1.2 million square feet of Class A office space at 280 Park Avenue for $1.2 billion at a 3.6 percent cap rate. That was partly done on expectations that new owners could rapidly squeeze out greater income thanks to skyrocketing office rents. The credit crunch and economic slowdown are significantly lowering purchase prices for Manhattan office properties, while rents have so far stayed mostly flat. These factors are contributing to a climate of rising cap rates. Cap rates increased by 50 basis points in the second half of 2007, according to investment sales brokers and market analysts, and rates are likely to rise another 50 to 100 basis points this year. Average cap rates for Manhattan office properties ticked up slightly to 5.52 percent in the first quarter, after falling fairly steadily from 9.33 percent in early 2003, according to PriceWaterhouseCoopers Korpacz Real Estate Investor Survey. "There is no question that cap rates are higher across the board," said Dan Fasulo, managing director at Real Capital Analytics. "The market is not discriminating by property type or market. Everybody is up." Cap rates are also becoming more important, particularly for smaller deals, where margins have an even greater role in the success of a deal. That's partly because with today's credit crunch, investors have trouble getting loans based mainly on bullish rent growth projections. A deal could have had a cap of 3.5 percent in the past and debt at 6 percent and still would have gotten done. Now, however, cap rates have become more of an upfront test of a deal's viability. "In the past, a cap rate might have been an end-of-line reality check thing: 'I've got through all of this and ended up with this cap; can I live with this? If the market hears I paid 2.5 cap, will everyone laugh at me?'" said Nat Rockett, managing director at Jones Lang LaSalle. "People today are much more cap-rate oriented, much more focused on positive leverage from the get-go." While cap rates will rise, the absence of major office sales leaves a dearth of numbers to crunch to figure out where cap rates are and how much they are increasing. In mid-April, investment sales brokers and analysts were focused on the Equity Office buildings troubled magnate Harry Macklowe had for sale and what price they would fetch, since the disposition of major assets he bought last year in a highly leveraged deal would provide a new bellwether for cap rates. "We will be able to tell as soon as the Macklowe sales happen," said Robert Von Ancken, an appraiser and executive managing director with Grubb & Ellis. Despite the uncertainty, there are a few deals analysts point to as examples of the uptick in cap rates. One is the Milk Studios building at 450 West 15th Street. That sold for $160 million late last year at a 5 percent cap. When it hit the market earlier in 2007, the property was expected to sell for $200 million, which would have been a 4 percent cap rate. Another example is SL Green's $1.575 billion buy of 390 Greenwich Street last December from Citigroup, which had a cap rate of 6.3 percent. Fasulo estimated that prior to the credit crunch, this deal would have missed a 6 percent cap rate. Rising cap rates are part of an overall climate that favors cash-rich investors such as pension funds or foreign buyers. Not only are they now able to do deals, because they don't need to take on substantial debt, but higher cap rates mean the transactions generate a higher return. Sellers, though, are resisting the upward march of cap rates. "It's a silver lining for buyers, sure, but now there's a dearth of transactions because sellers don't want to hear it yet," said Craig Evans, senior managing director at Colliers. Cap rates typically rise in a recession. How far they will rise depends on how intense and prolonged the current economic downturn proves. For now, analysts expect cap rates to plateau before hitting historical levels of 7 to 9 percent. "While cap rates are certainly a little higher than they were at the top of the market, I really don't see a future environment where cap rates return to levels of the 1990s, which is significantly higher than now," said Fasulo.

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