Mark Mascia
[Editor's Note: This is a guest post from Mark A. Mascia, President and CEO of Mascia Development. It's not particularly physician-specific, and I came very close to rejecting it outright for that reason. However, I thought the ideas it explored were very interesting and worthy of publication. In this post Mr. Mascia tries to determine which real estate markets nationally are undervalued or overvalued, and how rising interest rates might affect that. This has important implications for those interested in investing either directly in properties in their home town, or indirectly via a syndication company. We have no financial relationship.]
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.
My firm assessed commercial property value and prospects in all fifty states, looking for US cities with the best opportunities for long-term, stable growth. Our valuation criterion assessed multiple factors, including diversity and strength of employer base, 12-year population growth trends and current cash returns on investment grade real estate. We did this while looking for the best investment opportunities for our real estate fund. The analysis also highlighted the worst commercial real estate markets for investors based on the current bubble-like pricing and un-sustainable rental growth projections.
“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.
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%
What do you think? Where are your real estate investments? Did you pay attention to valuations when you bought them? How would this information change the way you invest in real estate? Do you agree with the author's rankings? Why or why not? Comment below!
Featured Real Estate Partners
I am glad you included the post. I found it interesting.
It will be interesting to see what happens with rates, as of now they are dropping and below 4% again. Maybe the market is trying to convince the fed to keep pumping the money or there is really no way to stop some level of deflation.
Interest rates cant really rise (without a concurrent and equal price drop) as that would basically shut out the rest of the remaining buyers, which arent many. The underlying economic principles just arent there. For the greater economy the median wage hasnt moved, and investors and foreign cash buys are all but drying up. Add in that inventory has likely been overbuilt by the millions (while being valued during a spectacular bubble) and it doesnt make much sense. This will be a slow climb, hopefully back to a more sane market.
Excellent article. It’s not physician specific, but it was well written and informative!
Can anyone help me better understand the statement “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 investor”?
Doesn’t capitalization rates going up means a higher return for the investment, so why would there be a loss in value?
Thanks!
Cap rate is Net operating income divided by the value of the property. If the income doesn’t change, then the only way for the cap rate to go up is for the value of the property to go down. In the long run, it may boost returns, just like when interest rates go up with bonds. But in the short run, that drop in value can be devastating.
Thanks! I guess that kind of makes sense, though it would seem like a very roundabout and backwards way of saying what you’re saying, but:
1. How would the math work, where the property value goes down by 33% but your cap rate goes up just slightly from 4% to 6% ?
2. How does this fit with the subsequent statement that “rents would need to grow by 50%” in order for the investor to “break even” ?
1. Let’s take a $150K property with a 4% cap rate. So your NOI is $150K*4%=$6K. If your property went to $100K, but your cap rate went to 6%, your NOI would be $6K. Cap Rate = Net Operating Income/Property value
2. Good question for the author, but I think he’s just playing with the equation listed above. If your cap rate changes due to a loss of value, in order to get your property value back to what it was, you’d need 50% higher rent (which would in turn increase the value of the property) to get back to even.
Thanks WCI!
My question may be off topic, but has anyone considered using a Service like Homeunion.com to scout out potential properties and hold your hand through the rental property management process? I have owned two rental homes since I started med school–always renting to medical students. I’ve been lucky so far with a great return on my initial investment. Just wondering if these companies really add any value…
If anyone has first hand knowledge of Homeunion.com or any similar service, I’d love to hear from you.
Finding a great property management service is tough. The margins are so thin they’re really in the property acquisition business. They need hundreds of properties to make a profit. Plus, no one cares about your property like you do, including the tenant and the property manager!