Market forecast

Late-Stage Cycle

More investors than investment opportunities exist, but the up cycle is nearing its end.

While core market pricing has held steady since 2015, for the past 18 months a softening in secondary markets has occurred. This slump may preview what will happen in all markets. For example, higher yields are available in suburban office parks, although the flight to the urban center to attract millennial talent may start to shift this dynamic.

Overall, multiple metrics and indicators suggest that commercial real estate properties are in or nearing a late stable stage of the market cycle for most property types in nearly every local market. Many property types in markets such as Washington, D.C., and Houston appear to have surpassed peak conditions at this point, though there is no obvious reason to expect a significant downturn.

After a sharp rise in yield on the benchmark 10-year Treasury bond, interest rates have stabilized and, in fact, come down this year on both an absolute and effective basis as spreads have tightened. The economy continues to plod along at a 2 percent estimated annual gross domestic product growth rate.

 In most markets, supply appears to be met with commensurate demand, although a few markets such as multifamily in Los Angeles and office in San Francisco are exceptions. Finally hobbled by regulation, the banks continue to prune their portfolios and to be tentative about approving new loans, particularly construction loans.

 Even on relatively stable assets, bank lenders rarely offer more than 60 percent financing, so mezzanine players and alternative lenders have had to fill the gap. This situation differs from 2006, when anybody who could fog a mirror got a loan, often at 85 percent loan-to-cost, for the senior tranche.

Unbalanced Retail

Retail is the notable exception to this relative stability. Almost every day, headlines of store closings and national retailers filing for bankruptcy fill national news outlets and real estate publications. Certainly not every retail sector is performing poorly, but there are headwinds across the sector. It looks likely the retail market will get worse before it gets better.

In addition to the apparently adverse impact of internet retailing, the overall retail sector finally is facing up to years of significant overbuilding. In part this comes from municipalities' willingness to greenlight projects with the expectation of filling their sales tax coffers, regardless of the economic demand.

Overall, however, economic and demographic drivers are still propelling increased demand, though construction activity is catching up in some instances. And as inventory nears equilibrium, operating fundamentals are positive but moderating.

Overall Stability

On the capital markets side, conditions seem relatively unchanged since the end of 2016. Though still above long-term averages, transaction volume was down in Q1 2017 and looks to decrease more in Q2 2017.

Anecdotal evidence suggests that brokers' opinion of value requests is increasing, and that more commercial properties will be offered to the market in the second half of 2017. But market uncertainties remain, such as interest rate hikes and global politics and policy, which could affect local markets.

The amount of capital available and seeking investments continues to exceed the opportunities. Moderating fundamentals, however, appear to be neutralizing the impact on pricing, in addition to significantly smaller bid pools than those that existed in 2015 and early 2016.

On the debt side, demand likely exceeds what lenders are willing to commit, particularly for noncore investments, and lenders' cost of capital will likely increase this year along with the federal funds rate.

While it is unclear whether the commercial real estate industry will experience further rate hikes this year, long-term upward momentum is exerting pressure on rates, which in turn leads to downward pressure on pricing. Of course, if the increase in interest rates is due to real growth of higher than 3 percent rise in GDP, most of this downward impact on pricing should be offset by increases in income. 

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Marty Caverly

Marty Caverly is senior vice president of the resource income and opportunity REIT at Resource Real Estate in Philadelphia. Contact him at mcaverly@resourcerei.com

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