The Year Ahead In Commercial Real Estate

Aided by an increasingly diverse pool of active investors, rapidly improving credit conditions and stabilizing property fundamentals, commercial real estate investment trends in the nation’s largest markets developed significant momentum over the course of 2010.

Despite disconcertingly weak economic and labor market outcomes, investor optimism about the sector’s asset price trajectory has supported more intense bidding for properties, giving traction to the process of price discovery and driving cap rates lower for well-tenanted properties in every sector. Absent a derailment of investor sentiment or a sharp downside deviation from the baseline economic and capital markets outlook, the stage is set for further gains in investment activity across a broader range of the nation’s markets in the new year.

Doubling Last Year’s Record Low

Sales of significant commercial properties in the domestic United States reached $8.7 billion in November, as reported last week by Real Capital Analytics. The most recent findings bring year-to-date transaction volume to $90.7 billion, more than double the same period last year. With an additional $5.1 billion already closed in the first weeks of December, and with additional closings currently pending, transaction volume in 2010 will easily surpass the $100 billion milestone before year’s end.

Coinciding with these trends in sales volume and a rebalancing of market share toward larger deals and institutional-class investors, key pricing metrics have firmed as buyers have bid more aggressively for high-quality, performing assets. The office and apartment sectors exhibit the strongest headline trends; hotel trends are choppier, and retail and industrial assets have measured healthy but more modest improvements in demand.

Since the beginning of 2010, average cap rates have fallen measurably across each of the sectors, from a decline of 65 to 70 basis points (bps) for industrial and retail properties to a sharper drop approaching 200 basis points in the office sector. In the latter case, cap rates have fallen from an average of 8.9 percent in December 2009 to 7.1 percent as of this November. Cap rates for apartment transactions remain the lowest of any sector, falling to an average of 6.4 percent nationally as evidence has mounted of a sustained improvement in occupancy rates and asking rents.

While the apartment and office sectors’ November average cap rates might have seemed implausibly low by forecasters making projections in 2009, the results convey the extent to which investors have focused on a small subset of geographic locations with strong liquidity characteristics. These major markets-including Boston, New York City, Washington, D.C., Chicago, San Francisco and Los Angeles-have accounted for roughly half of transaction volume nationally in 2010. Even within these markets, the transaction mix in 2010 has in no way been an unbiased and random sampling of the inventory. The elevated inflows of capital into major markets, coupled with a finite supply of assets for sale that meet investor criteria, have necessarily exerted upward pressure on prices.

Is It Too Much, Too Soon?

Will the near-singular focus on major markets give way, with investor interest rebalancing in favor of a greater diversity of opportunities in 2011? Significantly lower cap rates for the most attractive assets inevitably push investors further out on the perceived risk spectrum. In fact, the most recent trends evidence buyers’ willingness to diversify into a wider range of geographic markets, albeit with a continued focus on high-quality properties with strong tenancy characteristics. The emergence of a strong CMBS pipeline for the first quarter also suggests that credit is improving for prime assets in secondary and some tertiary markets, facilitating a larger range of trades.

In contrast with these positive spill-overs into prime assets across a greater geography, investments into lower-quality assets that do not present a clear value-add opportunity are not a dimension of risk-taking that investors are ready to engage in as yet. For underperforming properties, the risks to the labor market recovery must abate to a greater degree. The focus on quality and the aversion to macroeconomic risks are key factors in the variation in outcomes across property types as well, with apartment and office property trends leading trends while retail properties have measured healthy but relatively more modest improvements.

What of 2011?

Whether in primary markets or further afield, the positive trends in headline transaction volume will continue into 2011, barring a serious reversal in the underlying economic and labor market recovery. But in measuring this recovery, investors will have to remain vigilant, particularly as concerns the complex, nonlinear relationship between broad interest rates and cap rates. In the realms of public and private markets, and at their juncture, significant risks will continue to exert drags on consumer and business confidence in a way that is material for the commercial property outlook.

Potential challenges range from the unwinding of monetary and fiscal policy interventions, including the interest rate outlook in light of rising treasury yields, to the continued intermediation of distress, to the fate of Fannie Mae’s and Freddie Mac’s multifamily lines of business. Given this unique environment of uncertainty, and in planning for 2011, investment strategies that anticipate the need for flexibility as opposed to relying on a rigid and deterministic outlook remain critically important.(Credit schandan-rcanaylytics)

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