The stresses of the world still exist some eight years after the Great Recession. A continued global economic slowdown now includes China, new acts of terrorism abound, and the Federal Reserve is raising the federal funds rate just as other central banks increase their quantitative easing efforts.
Despite these concerns, the investment climate for commercial real estate continues into 2016 with amazing momentum, attractive to many from a price and asset class perspective. This reality exists for various reasons: The U.S. economy remains strong compared to other economies; interest rates remain low; and capital continues to pour into this asset class, which is helping to further drive up prices and values.
In fact, from a price perspective, the headlines from 2015 couldn't be more telling:
- GE Capital's real estate assets sold for $26.5 billion, the largest deal since Blackstone's acquisition of Equity Office Properties Trust in 2007
- Chicago's 110-story Willis (formerly Sears) Tower sold for $1.3 billion to Blackstone Group and Wells Fargo, the highest price per square foot paid for a U.S. office tower outside of New York City
- Marriott purchased Starwood Hotels & Resorts Worldwide for $12.2 billion, creating the world's largest hotel company, with more than 1 million rooms globally; and
- Stuyvesant Town and Peter Cooper Village in New York City sold to Blackstone Group and Ivanhoe Cambridge for$5.3 billion, which is about the same price it garnered prior to the credit crisis.
Across the broader market, investors tend to agree that commercial real estate is worth its high-priced luster. Each quarter, Situs RERC surveys the investment practices and opinions of commercial real estate investors. In third quarter 2015, their survey responses indicated that commercial real estate was the highest-rated investment alternative when compared to stocks, bonds, and cash. The rating dropped slightly from the previous quarters, indicating that the asset class may have lost a little favor as pricing and risk increased. Interestingly, the rating for other safe harbor investments such as cash and bonds increased slightly, while the rating for the riskier stock market tipped downward.
Warren Buffet offers some tried and true investment advice that relates to today's commercial real estate market. “You're dealing with a lot of silly people in the marketplace,” he said in a 1974 interview. “It's like a great big casino and everyone else is boozing. If you can stick with Pepsi, you should be OK.”
In this case, if we compare commercial real estate to Pepsi, and other investments to a casino where the liquor is flowing, commercial real estate looks quite attractive-especially given the volatility of the stock and bond markets, current low interest rates, and returns associated with commercial real estate. However, the test for investors is to keep their heads about them and not get caught up in effervescent pricing in certain markets.
The Seller's Market Continues
With higher prices for institutional properties in the major markets, as well as increasing prices in the secondary and tertiary markets, 2016 should see more assets brought to market as sellers recognize an opportunity to take advantage of the favorable pricing. In 3Q15, Situs RERC's rating to “sell” commercial real estate increased to 7.7 on a scale of 1 to 10, with 10 being excellent. This is the highest sell rating since 2Q07. Meanwhile, the ratings for “buy” and “hold” decreased to 5.3 and 6.5, respectively.
However, even with the decline in the buy and hold ratings, it is worth stating that these ratings remain above 5.0, the midpoint of the scale, indicating that the buy and hold strategies are still rational, depending on the property type and expected return on investment.
In fact, these strategies remain rational as long as interest rates remain low, which also allows capitalization rates to remain low. As a result, the spreads between Situs RERC's 3Q15 required going-in cap rate and pre-tax yield rate averages for all property types vs. the 10-year Treasury rates are 400 and 570 basis points, respectively. These are reasonable in light of the alternatives. As demonstrated in Figure 3, the spreads were 230 and 390 bps, respectively, in 4Q07, just prior to the credit crisis and the significant price and value loss that followed in 2008 and 2009.
This is good news for sellers, who have been finding buyers willing to pay high prices in the primary markets, as well as in many of the secondary and tertiary markets now. However, as more assets are brought to market, buyers can maintain some level of discipline as they see more investment choices.
Situs RERC's institutional investment survey respondents maintained that value in commercial real estate was strong but properties were pricier in 3Q15. As such, the 3Q15 value vs. price rating for commercial real estate overall declined to 5.0 on a scale of 1 to 10, with 10 demonstrating very high value. This rating indicates that the asset class is fully priced and price is equal to value. (See Figure 4.)
However, the majority of the individual property sector value vs. price ratings increased in 3Q15, led by the industrial sector rating, which increased to 5.8. The next highest ratings were for the office and hotel sectors, which increased to 5.3. In contrast, the retail sector value vs. price rating declined to 5.1, indicating that retail properties have generally lost some value compared to their price. The value vs. price rating for the apartment sector, which served as the “go-to” property investment early in the recovery, remained at 4.6, with apartment properties generally overpriced compared to their value.
Valuation underwriting metrics and assumptions are starting to have a difficult time keeping up with prices in some markets, and this is likely to continue in 2016 in fully priced primary markets such as New York City and San Francisco. However, given the attractiveness of commercial real estate in this investment environment, we can expect prices and values to continue to increase in 2016 in some secondary and tertiary markets - although the pace of the increase is likely to slow from that experienced in 2015, especially in the top markets and choice property types.
Property Types Up Close
Office. Vacancy in the office sector improved in 3Q15, declining by 10 bps to 13.4 percent according to CBRE, and the average annual gross asking rent rose 1.3 percent to $29.36 psf on a quarterly basis. Although net absorption was lower than the previous quarter with a total of 41.6 million sf in 3Q15, it remained higher than the quarterly average since 2000, according to CBRE. Office volume has declined, with 12-month trailing transaction volume falling 13 percent to approximately $10 billion in 3Q15, according to Real Capital Analytics. While average price psf declined slightly to $243 on a quarter-to-quarter basis, the average price remained slightly higher than year-ago prices. Situs RERC's weighted average required pre-tax yield rate, or internal rate of return, increased to 7.9 percent in 3Q15, while the weighted average required going-in cap rate was unchanged at 5.9.
Industrial. During 3Q15, availability decreased to 9.6 percent, according to CBRE. Net absorption totaled 56.9 million sf and remained positive for the 22nd consecutive quarter. Furthermore, rents grew by 1.4 percent compared to the previous quarter, and rose more than 5.6 percent from a year ago. An additional 5.6 percent growth is expected in 2016. Total transaction volume rose 8 percent on a yearly basis to approximately $4.6 billion in 3Q15, per RCA. Average psf rose to $81 from the previous quarter, and showed the most significant increase among the property sectors on a year-over-year basis. In 3Q15, Situs RERC's weighted average required pre-tax yield rate for the industrial sector was 7.6 percent, while the weighted average required going-in cap rate increased 10 bps to 6.0 percent.
Multifamily. The vacancy rate for the apartment sector was unchanged at 5.0 percent during 3Q15, while the annual effective rent growth increased 4.9 percent, according to Axiometrics. By the end of 2016, vacancy is expected to increase slightly and, as a result, rent is expected to decline. Twelve-month trailing transaction volume declined 11 percent to around $11 billion in 3Q15, according to RCA, although the average price increased to $133,513 per unit. Situs RERC's required pre-tax yield rate increased 10 bps to 6.9 percent in 3Q15, while the required going-in cap rate was unchanged at 4.8 percent.
Retail. The retail sector recovery remained uneven during 3Q15, with most of the demand focused on top-tier properties, according to CBRE. Net absorption rose 4.3 million sf. The availability rate for the neighborhood/community sector was stable at 11.4 percent compared to the previous quarter, while rent growth rose 1.1 percent on a yearly basis. Total transaction volume declined 8 percent from a year ago to about $5.7 billion in 3Q15, while the average psf increased 3 percent from a year ago to $213 in 3Q15, according to RCA. While the weighted average required pre-tax yield rate for the retail sector was stable at 7.6 percent, the weighted average required going-in cap rate increased 20 bps to 6.1 percent in 3Q15, according to Situs RERC.
Hospitality. U.S. hotel occupancy increased 1.4 percent to 71.3 percent on a YOY basis in 3Q15, according to STR. The average daily rate rose 4.5 percent to $122.60, while revenue per available room, or RevPAR, increased 5.9 percent to $87.47. In 2016, STR forecasts that hotel sector occupancy will increase 0.8 percent to 66.0 percent on a YOY basis, ADR will rise 4.8 percent to $126.28, and RevPAR will increase by 5.7 percent to $83.39. Situs RERC's required pre-tax yield rate declined 10 basis points to 9.0 percent in 3Q15, while the required going-in cap rate increased 30 basis points to 7.1 percent.
Let the Buyer Beware
Although prices are pressuring values, the value of commercial real estate - especially compared to other assets - continues to be quite significant. We anticipate global, national, and local demand for this asset class to continue in 2016, especially in certain property sectors and markets.
Commercial real estate is a hard asset, and as such, is something of real value vs. on paper only. Fundamentals are generally good, and rents and vacancy rates are expected to continue to improve in 2016. For the most part, new construction has been held in check. Real estate offers a certain amount of economic stability by providing income, which is quite reasonable on a relative basis. In addition, commercial real estate can serve as a hedge against inflation.
However, it is also important to note that, similar to 2007, increasing prices are putting investors at risk. The higher prices rise and the longer this trend continues, the bigger the risk - especially if long-term interest rates start to increase.
Even if interest rates do not increase too much, as we expect, risk is still increasing. Although we expect commercial real estate to continue to do well in 2016, given today's high prices, the cautionary phrase “caveat emptor” should remind commercial real estate investors to keep their heads about them and conduct careful due diligence prior to their purchases.
What Will Happen with Long-Term Rates?
RERC recently examined three likely directional scenarios for 10-year Treasury
rates — and hence, the direction of long-term interest rates.
- Excess profits. In this scenario, the economy
begins expanding at a faster rate than expected as a result of a strong global
economic recovery. The Federal Reserve raises short-term rates gradually over
the next few years, and then more drastically in 2019 to stave off inflation.
- Constrained growth. The economy continues to
grow slowly and the Federal Reserve raises short-term rates very slightly. Over
the next five years, the economic climate and rates are likely to be very
similar to those of the past five years.
- Financial repression. Due to the substantial
debt-to-gross domestic product ratio of the U.S. and other developed economies,
it is plausible that 10-year Treasury rates will actually decline as the U.S.
seeks to reduce its debt in real terms by keeping government bond yields below
the rate of inflation. This policy was used during the 20 years after World War
II, when the developed debt-to-GDP ratio was as high as it is currently.
the constrained growth scenario, which is the most likely, the Federal Reserve
will increase short-term rates but we do not expect it to significantly alter
the long-term rates for 10-year Treasury rates as the interest rate curve will
flatten out. This is the Situs RERC outlook for interest rates for the next few
years, and is what supports our continued view of the attractiveness of
commercial real estate for 2016 and into early 2017.