Capital Markets Outlook
Will rising interest rates stall commercial real estate activity?
capital flows, from both equity and debt sources, are boosting the liquidity of
the commercial real estate market and driving transaction activity. Equity
capital of all stripes — from local investors and 1031 exchanges to
institutions that include real estate investment trusts, private equity, and
sovereign wealth funds — have accelerated acquisitions and portfolio
repositioning to capitalize on the low cost of capital, consistent revenue
streams, and rising prospect for appreciation.
same time, lenders are back in full force just a few years after the banking
crisis. The volume of commercial mortgages, after dropping about 10 percent
during the credit crisis, reached a new high at midyear, rising by $140 billion
over the past 12 months. Commercial banks have picked up activity in both
fixed- and floating-rate loans, commercial mortgage-backed securities volume is
strong a second year in a row, insurance companies and government-sponsored
agency lenders remain competitive, and mezzanine funds abound.
of liquidity has pushed property prices to record or near-record levels in core
markets and is in the process of working its way to secondary and tertiary
markets. Property sales are growing in nearly every metro, but investors are
increasingly targeting assets in non-core markets as they pursue yields and
opportunities with less fervent bidding activity.
increased liquidity reflects the generally positive outlook for commercial real
estate, but the strengthening economy has also supported momentum. Gross
domestic product has risen steadily over the last several years — aside from
temporary setbacks such as the polar vortex of the first quarter — and the
outlook remains positive through the end of 2014.
addition, steady hiring has finally surpassed the 8.7 million jobs lost during
the recession, and by year-end, the U.S. economy should employ 1.7 million more
people than the pre-recession peak. Though many remain underemployed or have
left the labor force, the hiring trends continue to point in the right
direction. This combination of steady growth has allowed the economy to spur
demand for commercial real estate while minimizing risks of inflationary
gains have supported limited income growth, but the surging stock market has
helped household wealth significantly. As of the end of first quarter 2014,
U.S. household wealth was up 19 percent from its 2007 peak and more than 47
percent from the trough in 2009. That has supported rising consumer confidence and
substantive gains in retail sales. These steady positive factors will support a
growing demand for commercial real estate space on a broad basis.
years of low interest rates have helped the real estate market recover from its
downturn with a lot less pain than would have been imagined in the wake of the
2008 credit crisis. The rapid recovery in asset values and rebound in lending
have reduced the severity of what many thought would be a second thrift
liquidation-style event. Increasing economic strength in recent months has
lifted the prospects that the Federal Reserve will begin raising its short-term
rates early next year, posing limited risk to the real estate momentum.
interest rates are unlikely to rise quickly enough to slow the economic
momentum because demand for U.S. Treasurys remains robust. International
investors in particular have sought out the security of U.S. Treasurys as a
range of uncertainties plague parts of the world. While China has cut back its
purchases, investors from Japan, Europe, and the Middle East have picked up the
slack. Risks of escalating aggression in Ukraine and the Middle East cement the
perception of the U.S. as a beacon of stability.
What’s more, the Fed is under little pressure to
increase rates. The U.S. economy is improving, but inflation has remained in
check and the Fed remains focused on the large number of workers that have
dropped out of the workforce or are underemployed. The November elections are
another wildcard that could re-ignite gridlock in Washington, D.C., and stall
the nascent growth cycle.
Consequently, the Fed is unlikely to raise the
federal funds rate until the signs that the economy is heating up really
accelerate. Presently, most anticipate that this will not happen before the
middle of next year, but there is a chance that the Fed will surprise and begin
tightening liquidity sooner.
rates do begin to rise, the impact on commercial real estate may be nominal.
Historically, capitalization rates have not moved in lockstep with interest
rates, with tightening spreads being the norm during most growth cycles. As a
result, should rates begin to rise later this year or early in 2015, it remains
unlikely that cap rates will escalate in pace.
cap rates are near historical lows today, the risk premium — the spread between
10-year Treasury yields and cap rates — persists near historical highs. If
Treasury yields rise because of positive factors — such as strong economic
growth — investors will have a more optimistic outlook about property
performance and be willing to absorb some of the rate increase in the form of
lower risk premiums. The bottom line is that, aside from a major exogenous
shock, interest rates and monetary policy are not likely to have a watershed
impact on the economy or commercial real estate in the near term.
Real Estate Performance
real sense, the moderate pace of the economic recovery has been good for
commercial real estate performance. Usually new construction comes roaring back
after recessions, but incremental growth and the fresh memory of the severe
recession has kept development largely in check. Construction is creeping back,
particularly for apartments, but it is predominantly centered in core areas of
the strongest metros. Supply factors will be slower to emerge and less
problematic this cycle than in past recoveries.
Apartments have been a favorite asset class for investors since the downturn.
Not only did fundamentals remain more stable during the recession, but debt was
available from government-sponsored agencies when other lenders tightened their
lending criteria. Earlier this year, Fannie Mae and Freddie Mac reined in their
lending, and their share of multifamily loans fell to 47 percent in 2014, down
from 87 percent in 2009, but it appears they are increasing their allocations
through the second half of the year. In addition, banks, insurance companies,
institutions, and CMBS programs have stepped up their pace of lending,
producing a highly competitive lending environment. Loan rates are mostly in
the 4 percent range but can go as low as the mid-3 percent range depending on
the term, leverage, and borrower credentials.
pricing of premium assets in core markets selling with cap rates in the 3 percent
to 4 percent range, investors are increasingly moving to secondary and tertiary
markets in search of yield. But even those markets are becoming more expensive,
as average cap rates for high-quality apartment properties reach below 7
Investor demand in core markets remains intense. In the first half of 2014, 40
percent of the $50 billion of office sales came from six core markets where
class A properties trade at cap rates in the 4 percent range. However,
investors pursuing stronger yields and a less-competitive bidding process are
increasingly branching into secondary and tertiary markets, where sales
increased by 30 percent during the first half of the year. With suburban
offices in many metros offering investors a 150-basis point yield premium
relative to CBD office assets, investors have begun to search beyond core
accessible debt capital has also fueled activity this year as loan spreads have
tightened by 25 bps from last year. Rates range between 4.4 percent and 5.25
percent for 10-year loans with moderate leverage, and leverage up to 70 percent
is common. All lender types have become increasingly active, but national banks
have increased their share of lending activity to 26 percent. CMBS will also be
a positive factor, and it has already increased lending to this sector by $6.1
billion from last year.
Nationally, vacancy rates of retail properties have been tightening, as modest
absorption has topped the limited construction pipeline. In the year ending in
the 2Q14, only 37.4 million square feet of space, or 0.5 percent of total
space, came on line. This gradual tightening of vacancies has recently sparked
rising asking rents, but rents still remain about 11 percent below their
the still-soft performance climate for many retail assets, investor demand is
strong, particularly for single-tenant properties that are leased to national
tenants. The volume and number of transactions between $1 million and $10
million reached a record $10 billion in the 1H14, while price per square foot
and cap rates also hit new heights. Multi-tenant sales are also strong,
although shy of peak prices. The availability of debt continues to improve,
though lenders remain focused on stabilized properties. Local and regional
banks are increasing market share, while CMBS is dominant in secondary and
Investors seeking relative stability and diversity to augment existing
portfolios have increased demand for industrial assets. In addition,
institutional investors have targeted portfolio assets to build a critical mass
of assets in a given locality. Cap rates are tightening for all industrial
segments, with warehouses making the biggest gains. Warehouse cap rates
averaged 7.2 percent nationally in 1H14, and top properties in major markets
traded at yields under 6 percent. Flex properties averaged 7.8 percent cap
rates nationally in the first half.
are actively lending on industrial properties, although underwriting remains
relatively conservative. National, international, and regional banks increased
their share of industrial loans to 62 percent in 2013, up from 48 percent the
prior year. Lenders have largely targeted debt yields of 8.5 percent to 9
percent, producing leverage of 70 percent, while offering longer term rates of
4.6 percent to 5.5 percent.
E. Hughes is senior vice president and managing director of Marcus &
Millichap Capital Corp., based in Irvine, Calif. Contact him at email@example.com.