Two Major Disconnects
by Lawrence Yun, NAR Chief Economist
We need to be mindful of two major disconnects that are present in the commercial real estate market. First, large properties with high price points have been doing much better than small properties with low price points. This trend came about because the smaller-size deals require lending principally from local community banks, and the new financial regulations have greatly raised the cost of doing business for the smaller guys. Fortunately though, after a lengthy wait, the small property deals are occurring and increasing due to steady job creation in the economy. So, as long as job creation continues there should be more deals in the making for commercial practitioners.
The second big disconnect is between solid commercial market fundamentals and worrisome property prices. Vacancy rates have been falling and rents have been rising—these are solid fundamentals. However, due to plentiful funds via Wall Street, pension funds, insurance companies, and other institutional money, big “trophy” properties in major cities have been bid up so high that the cap rates barely make sense. Therefore, when interest rates rise in 2017, the high-end property prices look vulnerable to some correction.
The Market is Hung but Cash Still Flows
by Jim Costello, CRE, Senior Vice President Real Capital Analytics (RCA)
The commercial property markets saw the highest ever 60-day period of transaction activity from December of 2015 through January of 2016. It is unlikely that we will see the same pace into the end of this year as buyers and sellers move apart on expectations. Still, deals will continue to happen and pricing will continue to remain tight.
Deal volume grew at double-digit rates from 2012 to 2015 as falling cap rates and low interest rates allowed buyers and sellers to see eye-to-eye on asset pricing. In recent months, however, the cap rate declines have stalled and interest rates, while not yet climbing, are expected to rise at some point. Transaction activity is down as potential buyers are underwriting with more caution in the current environment.
Still, current owners of commercial property are not leveraged to extreme levels as was seen before the Global Financial Crisis. Without some outside calamity that undermines the economy, properties will still be cash flowing and owners are not always going to be motivated to sell.
With greater differences on buyer and seller pricing expectations moving forward, the market is likely to be hung for a while, with lower overall volume but prices close to current levels.
Commercial Real Estate Performance: Good, Not Great
by Sara Rutledge, Director of Research, National Council of Real Estate Investment Fiduciaries (NCREIF)
Trends in the NCREIF Property Index (NPI) database suggest performance may have peaked. The quarterly NPI total return has edged down for more than the past four quarters to a level in-line its long-term average on deceleration in both the income return and appreciation. Appreciation strengthened to a cycle peak for the year in 2015, but has been trending down for the past two quarters. The annual income return has been slowly trending down over the past five years with market values rising faster than income. Yet, commercial real estate remains an attractive relative performer across asset classes, outperforming equities.
Occupancy among NPI properties stands at its highest level since 2001 and annual net operating income growth continues at an above-average pace. Market fundamentals differ by property type with apartment and office further along in their cycles than industrial and retail. This combination of attractive relative performance to other asset classes and strong fundamentals is supportive of capital flows into the sector, keeping cap rates low. Thus, the near-term outlook for commercial real estate performance is continued moderation. Simply put: performance should be good, not great.
Buildings Will Stay Rented and Value Will Increase
by Mark Dotzour, former Chief Economist and Director of Research for the Real Estate Center at Texas A&M and freelance economist
There are always two things on the commercial real estate investor’s mind: will my buildings stay rented and what will happen to the value in the next twelve months. While the US economy is getting aged, I think we still have maybe two more years of sluggish expansion that will continue to generate tenants. Property values are likely to continue to increase for quality commercial real estate because of the unprecedented manipulation and distortion of the credit markets by central banks in Europe, Japan, and the US. With bond yields further declining, commercial real estate will remain very attractive to global investors.
Pay it Forward: CRE Maintains in 2017
by Kenneth P. Riggs, Jr., CCIM, CRE, Chairman & President of the Real Estate Research Corporation (RERC)
Commercial real estate’s role as a foundation during uncertain times almost ensures that it will continue to be an attractive investment for the next 12 months. As a tangible asset that derives a majority of its return through annual dividends, commercial real estate is extremely attractive as we look to the future. Global uncertainties, including the assorted financial and political concerns like the UK exit from the EU, terrorism, and a slowdown in China, will continue. These, along with the challenges in the U.S. economy, with a rate of growth that is expected to remain stubbornly slow, will continue to be major headwinds for the global financial and capital markets. Commercial real estate will continue to be supported by historically low long-term interest rates. In addition, there are spouts of optimism through improved space market fundamentals and with supply and demand balances continuing to improve on a broad market perspective.
Commercial real estate will also continue to gain strength in the secondary and tertiary investment markets, as they finally rebound from the credit crisis of 2008 and reach a new normal. These gains will be especially bolstered by their local housing markets, which are expected to continue to demonstrate strength over the next year. Strength in the housing markets will result in an amazing ripple effect on local economies, as demand for labor from the trade professions and other skilled workers will drive growth in employment, personal income, and consumer spending.
As a whole these economists felt capital hungry for yield will meet a global economic slowdown at the cross-roads of the U.S. economy spurring modest but positive growth which is expected to bolster commercial real estate through a late-cycle that will continue to reward investment. As a commercial real estate professional continue to stay abreast of market developments through reports like NAR’s Quarterly Forecast so you can be best-prepared to handle any trends and their potential impact to your local business.
This article appears in the Commercial Connections issue Summer 2016: Building Opportunities, Community & Our Future.