Commercial real estate investment sales faltered coming out of the gate in 2016. Investment sales dipped noticeably in the first quarter compared to the prior year. Yet a gentle tap on the brakes in what has been a stable recovery is not cause for alarm. Economists continue to forecast a favorable outlook for transaction volume, absorption, and rent growth through 2016.
Investors pulled back early in the year as concerns flared due to volatility in the stock market, slowing growth in China, slumping oil prices, and widening spreads in commercial mortgage-backed securities. “There is nothing that stalls the market more than a plummeting stock market,” says Barbara Byrne Denham, an economist at Reis Inc. in New York City. The 1Q16 stock market gyrations created a ripple effect that showed up across the board in transaction activity and lending volume, she says.
On a year-over-year basis, investment sales dropped 20 percent in 1Q16 to reach $111 billion, according to Real Capital Analytics. Despite that dip, sales volume is still relatively high. Over the last 11 years, only two other first-quarter periods had deal volume that exceeded $100 billion. In addition, investors may have been due for a breather after 2015's near record high sales reached $543.2 billion, according to RCA.
In fact, last year's mega transaction volume may prove difficult to match. A number of large deals occurred in 2015 - both single-asset and portfolio deals - that helped boost the overall transaction level to its highest level since 2007. For example, in New York City. The Stuyvesant Town-Peter Cooper Village housing complex sold last fall for more than $5.3 billion, and the landmark Waldorf Astoria hotel also traded early last year for $1.95 billion. “There were a lot of big, well-known property sales and it is hard to come off of a year like that and think it will repeat,” Denham says.
But a sales decline is not necessarily bad news for the market, says Hugh F. Kelly, CRE, a professor of real estate at New York University. It is a sign that the commercial real estate industry is not moving in the direction of speculative excess as described by Anthony Downs a decade ago in his book Niagara of Capital. “I don't think we are seeing a flow of money that is like a force of nature that can't be stopped,” Kelly says. The fact that the market is showing more discipline is a healthy sign that we have learned some lessons, he adds.
The latest Urban Land Institute Real Estate Consensus Forecast, released in April, predicts continued economic expansion over the next three years, but at a somewhat slower pace than the prior two years. The forecast expects commercial property transaction volume to decline over the next three years to $525 billion in 2016, $500 billion in 2017, and $475 billion in 2018.
That deceleration is a natural part of a maturing market cycle that is more than six years into its recovery. “What we see happening is that the market is slowing down in alignment with what is more sustainable transaction levels,” says Ken Riggs, CCIM, CRE, MAI, executive managing director and president at Situs RERC in Houston. Going forward, transaction volume will flatten out more over the next 12 months, because it is a more mature transaction market and more mature market related to price versus value, says Riggs.
So, given the slower pace of transactions in the coming year, where is capital likely to move in the current climate? Investors are becoming more selective as they recognize it is not a case where a rising tide lifts all boats, says Kelly. Some sectors, such as hotels and trophy office assets are already at or near peak pricing and values. In addition, multifamily volumes have blown past where the peak was 10 years ago. “That is too much money flowing into multifamily, and it has driven capitalization rates down to levels where it hardly makes sense,” he says.
However, investors still have plenty of options across sectors to buy core, core-plus, value-add, and opportunistic properties. For example, multifamily is likely to continue to be a favorite, because of the strong demand and demographics, given that homeownership is at its lowest level in nearly 50 years. Industrial assets still have good upside, and buyers continue to pursue retail properties that are well-located or have a good tenant mix.
One question is how comfortable investors are going into smaller metros in order to capture higher yields. “Are they willing to go into secondary and tertiary markets where cap rates haven't come down as much as one might expect? I don't know that there is one blanket answer, because it is becoming more nuanced,” says Jeffrey Havsy, chief economist at Americas Research and managing director at Econometric Advisors at CBRE. Investors are digging deeper to figure out where there is potential rent and value growth, as well as what the risks might be in certain markets. It makes it a little trickier and takes a little longer to work through that analysis, Havsy says.
Property Sector Outlook
The ULI Consensus Forecast anticipates continued commercial price appreciation and positive returns, but at more subdued and decelerating rates; above-average but lower rent growth rates in all property sectors; and better than average vacancy rates in all sectors, except for retail.
Real estate owners and investors are still seeing growth moving at a healthy clip that is well ahead of the rate of inflation. One of the factors that could be dragging down those numbers is that, up to this point, the market has been improving amid very low construction numbers. Now that development activity is picking up, new supply is hampering growth in every sector except for retail, says Peter Linneman, NAI global chief economist.
Retail. Economists see retail as a bit of an exception in the broader industry forecast. Vacancies have been improving since peaking in 2011 at 13.1 percent and are expected to decline to 10.9 percent this year. However, those vacancies remain elevated, which is expected to produce below-average rent growth, according to ULI's forecast.
Retail also remains a bifurcated market. “Some of the best centers are full with great rent growth and they are just crushing it,” Havsy says. Meanwhile, there are other centers that are really struggling. “In retail, it really depends on location, physical structure, and tenant mix,” he adds. “But you have more winners than losers that are really separated than you do with some of the other property types.”.
Also, demand for brick-and-mortar space is growing even while the internet is chipping away at retail sales, notes Linneman. “The real blessing for retail is that there is virtually no new supply,” he says. In fact, the total amount of retail space is actually shrinking. A small amount of new space is coming online, but at the same time old and obsolete retail properties are being redeveloped or converted to nonretail uses, according to Linneman.
Industrial. The industrial sector has been holding its ground against headwinds that include a strong dollar, which is negatively affecting export volumes. Vacancy rates for warehouse and distribution space are expected to decline 40 basis points this year to 10.2 percent, according to Reis. During 1Q16, effective rents increased to an average of $4.57 per square foot, which is up 0.6 percent compared to 4Q15 and 2.1 percent over 1Q15.
Industrial has benefited from a rise in retail sales and growth in e-commerce, which drives demand for storage and distribution facilities. In addition, the sector could get a bigger boost from a rebound in home building. New home construction creates demand for items ranging from flooring and windows to appliances and furniture, which will help the manufacturing sector and also buoy warehousing demand.
Factors to watch in the second half of 2016 and into 2017 will be a spike in new industrial supply. “There is a lot of new supply coming online, and it is very possible that that supply, particularly to deal with online sales, is going to outrun the demand next year,” Linneman says. New construction during first quarter totaled 16.9 million square feet following the 19.3 million sf that was completed in fourth quarter, according to Reis.
Office. Office will continue to see a solid increase in demand and steady absorption, with more activity in the best CBD and best suburban locations. Vacancies dropped 20 bps in 1Q16 to 16.0 percent, according to Reis. The firm is predicting that vacancies will remain relatively flat this year with a slight decline to 15.9 percent by year-end.
Although 1Q16 was slower for office leasing, it follows 23 straight quarters of positive net absorption, notes Havsy. He expects positive net absorption in the office market this year, although the pace of that absorption is slowing. One reason for that is that the market is getting tighter. “Companies that are looking for a particular type of space or a particular location may have to work a little harder, because there isn't as much choice,” he says.
The lack of new construction has been a big help in an otherwise tepid office market recovery. Roughly 6 million sf of new office space came on line in 1Q16, which is slightly less than the 6.2 million sf that was completed in 1Q15, according to Reis. However, those deliveries will increase in 2017, and that is already starting to affect rents as tenants commit to leases in those new buildings.
Multifamily. By the numbers, multifamily remains a stellar performer with vacancies below 5 percent. Yet the building boom occurring in some metros is starting to create some softness in the market with new supply exceeding demand, particularly in the high-end, class A segment of the market. Vacancy rates ticked slightly higher to 4.5 percent in 1Q16, and Reis is predicting that rates will rise another 20 bps this year to 4.7 percent.
“In a lot of markets, they are still getting the rents they are asking, but those rent increases are not going to be as dramatic,” says Denham. So much more new supply is coming online than demand can fill, so rent growth will move forward at a much slower rate, she adds. Rent growth that was 5 percent in 2015 is expected to decline steadily to 3.5 percent over the next couple of years.
The Outlook for 2016
One of the economic indicators to watch closely in the second half of the year will be employment growth. “We are seeing layoffs and mixed messages on corporate profits. But at the end of the day it all boils down to how the employment market is flowing,” says Riggs. Over the past 12 months through March, the country added 2.7 million jobs with a national unemployment rate that has been holding fairly steady at 5 percent. The outlook for interest rates is another key factor for commercial real estate.
Barring any unforeseen shocks, the forecast for the remainder of 2016 is for the economy to remain on its same steady pace of growth. Economists are predicting that GDP growth over the next 12 to 18 months will range between 2.0 and 2.5 percent through 2018. The upcoming presidential election may slow some decision making as businesses wait to see which political party comes out on top. Investment transaction and leasing activity are both expected to pick up compared to 1Q16. Construction activity also will increase in many markets. “We're in a pretty good place. It's not too hot and it's not too cold, and that is a healthy place to be,” Havsy says.
Capital Spigot Remains Open
by Beth Mattson-Teig
Borrowers continue to revel in a financing market where
capital is both cheap and plentiful. Yet, as the same time, debt and equity
sources are more disciplined when it comes to deploying that capital compared
to the previous cycle.
Even as lenders have become more aggressive on rates or
terms to win deals in a competitive lending marketplace, they are still
sticking to underwriting requirements. “All of the regulation has really put
a big governor on them, which has resulted in lenders not getting ahead of
themselves,” says Ken Riggs, CCIM, CRE, MAI, executive managing
director and president at Situs RERC in Houston.
Volatility in commercial mortgage-backed securities spreads
in 2015 and into early 2016 did create some uncertainty in that market in late
2015 and into 2016. Specific to U.S. issuance, first quarter 2016 volume was
down 30 percent compared to the prior year at $19.0 billion, according to
Commercial Mortgage Alert. Although that may create some concerns for borrowers
that are more dependent on CMBS financing, such as deals in tertiary markets,
other lenders have been stepping in to fill the gap.
That liquidity is good news for borrowers looking to finance
new acquisitions and development projects, as well as refinance existing loans
made at the peak of the market in 2006 and 2007. Commercial loan maturities are
expected to surpass $400 billion annually in both 2016 and 2017 — approximately
$100 billion more than 2015 maturities, according to a CBRE 2016 capital
markets report. Although there is ample debt and equity capital available to
support refinancing this year, the report noted that maturing loans with credit
quality issues could be a bigger problem in 2017.
The consensus is that financing rates will continue to hover
at near historically low levels in the near term. Even though it is likely “one of
the great mistakes in history,” the Federal Reserve will likely keep the short-term rate
at 0.75 to 1.00 percent for the remainder of the year, says Peter Linneman, NAI
global chief economist.
Although the Fed only has direct control on
setting the short-term lending rate, some of the global uncertainty related to
slowing growth in China, lower oil prices, and Britain’s possible exit from the European Union will
keep demand higher for U.S. bonds, which likely means that the 10-year Treasury
also will remain low. “Our forecast for the long-term rate is that they
will stay low longer, and that is what we have seen,” says Riggs. “I
think that is going to continue, mainly because of the global pressures.
CCIMs Report Strong Start in 2016
by Sara Drummond
In contrast to commercial real estate’s shaky
first quarter, with transactions reportedly dropping 20 percent nationwide,
CCIMs paint a picture of brisk activity in their local markets, particularly in
“We’re still seeing a very high volume of transactions along
the Northern Gulf Coast,” says John Fifer, CCIM, a senior associate with Beck
Partners in Pensacola, Fla. “Institutional owners are active in this tertiary market,
helped along by the volatile stock market. Several clients are real estate
funds buying shopping centers or office buildings. They are being funded by
stock market refugees who need a safer place to invest.”
CCIMs in Savannah, Ga., Charleston, S.C., southern Indiana,
and Kansas City, Mo., also report strong 1Q16 activity for various reasons.
Savannah, like many small markets, lags the larger markets, says Ryan
Schneider, CCIM, principal and broker for Pier Commercial Real Estate. “Activity
continues to ratchet up as other markets cool. Historically, Savannah trails
the Atlanta market by 12 months in both recoveries and declines.” He
adds that outside investors are primarily seeking relief from the
more-competitive larger markets.
Charleston’s solid local economy is attracting businesses and
institutional investors, says Simons Johnson, CCIM, SIOR, vice president and
principal of Colliers International in Columbia, S.C., who specializes in
corporate industrial. “We are experiencing even more demand since the end of
2015, which was also an above-average year for demand,” he
says. “I see a consistent increase for the next 12 to 24 months,
with the unveiling of the Boeing, Volvo, and Mercedes manufacturing plants.”
The southern Indiana market of Jim Baker, CCIM, SIOR, of
Baker Commercial Real Estate in Jeffersonville, Ind., is tied to the logistics
market of nearby Louisville, Ky. Two new Ohio River bridges opening by year-end
have fueled “a land rush in southern Indiana for new warehouse and
distribution buildings near interstate exchanges,” he says. “I
expect this year to exceed last year, which was the second best year of my
Pat Murfey, CCIM, with Evergreen Real Estate Services in the
Kansas City metro market has also closed more and larger transactions in 1Q16,
compared to last year. Representing local investors and owners, he’s
selling older industrial properties for value-add conversions into breweries,
restaurants, offices, and residential space.
Jacci Perry, CCIM, of KW Commercial in Fayetteville, Ark.,
who focuses on land and industrial, says deals are more prevalent because the
MSA has reached more than 500,000 in population. “Northwest Arkansas is now on the
radar of companies looking to relocate to small metropolitan areas,” she
But despite the population increase, new home construction
remains modest. “Gone are the days of pastures with streets, curbs, and
gutters,” she says. “Builders typically build two spec
homes at a time, and banks work with them. No one builds 15 homes at a time
Even Houston, hit by layoffs of 115,000 workers, is not as
bad as people think, says Sandy Benak, CCIM, leasing manager for Granite
Properties. The office sales investment market has dried up, but office leasing
is holding its own, she says.
“There is a perception that things are worse in Houston
than they are,” Benak says. “The reality is that class A sublease
space is abundant, but the rest of the market is holding fairly steady with a
slight uptick in concessions but not necessarily rates.”
Still, several CCIMs commented that nothing lasts forever.
Enjoy 2016 but expect a correction in 2017.
Sara Drummond is the former executive editor of Commercial
Investment Real Estate.