Investors Press the “Pause” Button

By George Ratiu

After the accelerated growth of the past few years, commercial real estate markets seem poised for a breather. Although the 2008 financial crisis and ensuing recession carved off a significant chunk of market valuation, investors picked up the early signs of the rebound and have been funneling capital into real estate assets at an upbeat tempo ever since.

Six years after hitting the trough, CRE investment volume reached $543 billion in 2015, the second-highest total ever. last year’s performance also came within striking distance of the 2007 peak of $573 billion. In tandem with the rise in investment, commercial property prices have taken a vertiginous rebound path over the past half-dozen years, driven by strong appetites for apartments and downtown office assets, both of which reached new price records.

However, mindful of the historic downturn that lingers in the rear-view mirror, and with a possible market peak in sight, real estate investors greeted the signs of economic slowdown in the first part of 2016 with a contemplative pause. While pondering the Federal Reserve’s anticipated rate increases, China’s economic slowdown, weak U.S. gross domestic product growth and the European Union’s existential questioning, among others, commercial investors reached for the “pause” button.

Sliding Sales

The numbers tell the story. Following last year’s upbeat performance, commercial property sales dropped sharply during the first quarter of 2016. Investment volume in large cap markets totaled $111 billion, a 20 percent year-over-year decrease, according to Real Capital Analytics (RCA). During the first quarter, individual property sales, the backbone of CRE transactions declined 11 percent. Portfolio deals fell an even steeper 24 percent during the period.

Underscoring investors’ ambivalence, first-quarter capitalization rates were flat compared with the second half of 2015, averaging 6.7 percent for all property types, according to RCA. Year over year, cap rates were 30 basis points lower in the first quarter, largely on the strength of compression in the apartment and central business district office sectors. Pricing continued on an upward swing, registering a 9 percent increase during the quarter, according to RCA’s Commercial Property Price Index.

Additional price indices also advanced, as the Green Street Advisors Commercial Property Price Index rose 8 eight percent on a yearly basis during the first quarter, to 123.4, and the National Council of Real Estate Investment Fiduciaries (NCREIF) Price Index increased 9 percent year-over-year, to a value of 257.3.

Small-Cap Momentum

Less-noticed investments in the small-cap CRE space, mostly in secondary and tertiary markets, maintained momentum early in 2016. REALTORS®’ Commercial Real Estate Market Trends reported that investment sales volume in smaller CRE markets totaled $51.6 billion during the first quarter, a 9 percent year-over-year increase. The main concerns for investors in the small-cap space were a continuing dearth of available product and tighter bank lending.

The inventory shortage drove prices upward, with small-cap commercial properties trading at prices 5 percent higher than during the same period in 2015. Cap rates in the small-cap CRE space reflected fundamentals, averaging 7.2 percent across all asset categories. That translated to a 57 basis-point compression on a yearly basis.

In the wake of well-publicized warnings from federal regulators about exposure to CRE loans, banks responded by tightening underwriting standards. Equity capital continues to compete with debt sources for high-end deals; meanwhile, in small-cap markets, regional and community banks have taken a more cautious approach in recent months.

According to the REALTORS®’ Commercial Real Estate Lending Trends, at regional and community banks—which account for 56 percent of all lending in REALTORS®” CRE markets—compliance costs stemming from financial regulations have made a stronger impact on available capital for deals. Faced with rising operating costs and higher capital reserve requirements for CRE loans, regional and community banks held back on capital deployment.

The low interest rate environment provided the silver lining for CRE investors. The interest rate on 10-year Treasuries, a standard measure of risk-free investments, averaged 1.8 percent during the first quarter, the lowest point since 2013. Based on prevailing rates, the spread between cap rates and 10-year Treasuries ranged from 490 basis points in large-cap CRE markets to 540 basis points in small-cap markets, maintaining a healthy buffer for investors.

To sum up the second-half outlook for 2016:

• U.S. economic growth is expected to rebound moderately.
• Commercial real estate fundamentals are likely to stay on an expansionary trajectory that will be marked by declining vacancies, rising absorption and cash flows.
• Investors will take a more measured approach, likely leading to a softening of CRE prices.
• With cap rates in top-tier markets at very low levels, pricing for Class A assets may be the first to feel the squeeze.
• Meanwhile, in small-cap markets, where the recovery began only in 2013, prices are likely to keep climbing.

George Ratiu is director of quantitative and commercial research for the National Association of Realtors. He writes a quarterly column on economics and real estate for CPE.