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Commercial Real Estate Provides Foundation In Uncertain Times

January 31, 2013

By National Association of REALTORS® Research Team

When Real Estate Research Corporation (RERC), Deloitte, and the National Association of REALTORS® (NAR) began making plans to publish Expectations & Market Realities in Real Estate 2012, the already sluggish economy was starting to slow. The volatility in the stock market was becoming more pronounced as the second round of the government’s quantitative easing started winding down, and further increased as we witnessed the inability of politicians to come to an agreement about the nation’s debt ceiling. Then the market all but collapsed as the nation’s credit rating was downgraded from its AAA status, and investors—afraid the economy was about to fall into another recession—retreated to the safety and stability that investments like commercial real estate could offer.

As the year 2011 came to an end, fear and uncertainty had spread beyond the U.S., and Europe is being forced to focus on its own economic difficulties. The sovereign debt crisis has expanded beyond Greece and Portugal to Italy and Spain, and although there are moves toward strengthening the European Union’s response to their debt crisis, the risk remains that one or more nations may eventually default on their obligations and a new financial crisis, that could affect the West, will emerge. As a result, the investment world is even more uncertain while the relative safety of commercial real estate investment is even more attractive as investors look for “New Foundations in an Uncertain World.”

Capital Market Trends

More than two years after the credit crunch, money is starting to flow into commercial real estate. Commercial and multifamily mortgage originations more than doubled in the first half of 2011 compared to the same period a year earlier, although current activity remains subdued compared to the hyperactivity of 2006 and 2007.

Investor type loans for commercial mortgage-backed securities (CMBS) increased by 638 percent in second quarter 2011 compared to second quarter 2010, according to the Mortgage Bankers Association (MBA). During the past year, loans for commercial bank portfolios increased 150 percent, loans for life insurance companies increased 87 percent, and loans for government-sponsored entities (GSEs) increased 58 percent

According to the National Association of Real Estate Investment Trusts (NAREIT), the total market valuation of outstanding public REIT companies was $191 billion in 2008, rose to $271 billion in 2009, and increased to $389 billion in 2010. At the end of September 2011, the market capitalization value of REITs was at an all-time high of $435 billion.

Property Types

Office: Given that economic fundamentals have been dominated by uncertainty, office investors continued to favor high-quality stable properties in major markets (New York, Washington, D.C., Los Angeles, Boston, and San Francisco), with the average deal size increasing to $37 million in the first half of 2011.

According to Real Capital Analytics, in the first half of 2011, total transaction volume for the office market rose to $24.5 billion, a 77-percent increase from the same period in 2010. Pricing for office properties advanced 27 percent in the first half of 2011, averaging $209 per square foot nationally. Several inland metropolitan markets are expected to see office transactions exceeding the $1 billion mark, including Houston, Chicago, Atlanta, Seattle, Denver, and Phoenix.

With minimal new completions, the office vacancy rate has plunged by a stout 40 basis points, ending second quarter 2011 at 17.3 percent, according to Grubb & Ellis. However, with vacancy declines still at least 2 years away from equilibrium in most areas, rental rates have not yet begun to recover. Concessions are less generous than they were a year ago for Class A space, but Class B and C properties still are mired deep in a tenants’ market.

Industrial: With the manufacturing sector remaining focused on rebuilding inventories and the expansion of international trade, industrial property market sales totaled $10.7 billion in the first half of 2011, a 54-percent gain over first-half sales in 2010. According to Real Capital Analytics, 1,087 industrial properties changed hands in the first half of 2011, the majority of which were warehouses. Chicago became the largest market by dollar volume in the first half of 2011, followed by Los Angeles.

Pricing for industrial properties rose modestly during this time period, to $59 per square foot, and cap rates averaged 7.9 percent. The national vacancy rate for industrial space declined to 9.8 percent by June 2011, according to Grubb & Ellis, as demand totaled 62 million square feet, the strongest six-month performance since 2007. However, there was slowdown in activity toward the end of second quarter 2011. Net effective rents have stabilized and are increasing for large Class A distribution buildings, but broad-based rent growth is unlikely to begin for at least another year.

Retail: Despite decreasing consumer confidence and higher consumer prices, second quarter 2011 retail property sales volume was the highest since third quarter 2007, with almost $15.2 billion in transactions, according to Real Capital Analytics. The majority of deals involved strip centers and grocery-anchored community centers, and cap rates remained relatively stable, although the price per square foot declined to $146 in second quarter 2011 from $165 in first quarter.

Of the major commercial property sectors, retail suffered most from the housing collapse and the Great Recession that followed. The vacancy rate among all retail center types retreated slightly to 7.2 percent by midyear 2011, according to CoStar, as downward pressure on rents continued.

Multifamily: The apartment sector has continued to be one of the strongest performers in commercial real estate in 2011, with $22.9 billion of significant apartment properties sold in the first half of 2011. This is a 104- percent increase from the same period a year ago, as reported by Real Capital Analytics, and is due primarily to robust portfolio transactions.

Further, apartments have outperformed all other major property types (by nearly double) in terms of pricing, with an annualized appreciation rate of 15.08 percent through the first half of 2011. This was due in part to continued cap rate compression.

Annual effective rental rates for the apartment sector increased by 5.1 percent in second quarter 2011, accelerating from 4.5 percent during the same period in 2010, according to Axiometrics, Inc., while vacancies declined to 6.0 percent and concessions declined. Additionally, effective rent of $980 per unit per month in second quarter 2011 is back to the peak reached in second quarter 2008, setting the stage for new construction.

Hospitality: Transaction volume for the hotel sector in the first half of 2011 surpassed volume for the same period in 2010, but the momentum is slowing. Given a minimal portfolio pipeline and a falloff of CMBS lending, less transaction volume and pricing volatility may be expected through the remainder of the year.

According to Real Capital Analytics, unit pricing of lodging properties increased to an average of $175,000 per key, but August 2011 data indicates that average unit pricing per room has decreased by approximately 15 percent due to investors’ appetite for higher returns for mid-market properties vs. top tier trophy assets.

Although PKF Hospitality Research (PKF-HR) lowered its demand forecast to settle at 4.5 percent for the remainder of 2011, hotel occupancy is expected to increase to a level of 59.8 percent for the remainder of 2011. Although average daily room rates (ADR) continue to lag occupancy increases, PKF-HR has increased its annual ADR forecast for 2011 to 3.2 percent, slightly above the expected pace of inflation.

Outlook

A modest economic recovery is expected. The estimate for GDP growth is +1.6 percent in 2011 and growth is forecast for +2.0 percent in 2012. Consumption is estimated to grow +1.6 percent in 2011 and is forecast to grow +1.8 percent in 2012, while NAR estimates government spending growth at -1.9 percent in 2011 and forecasts government spending growth at -0.5 percent in 2012.

The Federal Funds rate is estimated at 0.1 percent throughout 2011 and 2012, and the prime rate is expected to remain at 3.1 percent during 2011 and 2012. The 10- year Treasury is estimated at 2.8 percent in 2011, and forecast at 3.1 percent in 2012, according to NAR. Office demand is expected to close 2011 with about 30 million square feet of net absorption, followed by 50 million square feet in 2012, according to Grubb & Ellis.

With completions expected to remain at roughly half the pace of absorption, the vacancy rate for the office sector is expected to decline to 17.1 percent by the end of 2011 and to 16.6 percent by the end of 2012. However, with job creation remaining weak, rents are not expected to increase significantly.

Unless economic conditions deteriorate further, the national industrial property market will end 2011 with a vacancy rate below 9.5 percent; by the end of 2012, vacancy is expected to decline to 9 percent, reports Grubb & Ellis. Net effective rents have stabilized and are increasing for large Class A distribution buildings, but broad-based rent growth is unlikely to begin for at least another year.

Look for retail sales to bump along at modest levels in 2011 and 2012, with retailers continuing to reposition their stores to take advantage of favorable rental rates or expansion plans. Properties such as grocery-anchored centers will continue to outperform the rest of the retail sector due to consumer spending habits. Transaction volume is likely to continue on an upward trajectory for the most desirable assets into 2012.

The overall outlook for the apartment sector indicates another robust year in 2012, given strong fundamentals, a decreasing homeownership rate, lack of new supply, and the availability of financing for multi-family investments.

Apartment completions brought about by new starts are not expected to materialize until the late 2012 through 2015 timeframe. Effective rent growth in the apartment sector is expected to peak at an annual growth rate of 5.8 percent in 2012 and to slow to 4.9 percent in 2013, according to Axiometrics.

As we move through an election year, very little change is expected in the lodging sector, and lodging metrics in 2012 are expected to build on the success of 2011. Despite gains in both hotel occupancy and ADR through mid-year 2011, the second half of the year is expected to be challenging in terms of maintaining corporate and transient demand as economic confidence may erode. PKF-HR has lowered their ADR growth forecast for 2012 to 4.8 percent.

 


By The Numbers is only a brief excerpt of the in-depth 50-page publication “Expectations and Market Realities in Real Estate: New Foundations in an Uncertain World.” Find out why “commercial real estate is positioned to possibly deliver what it signaled so many decades ago when big institutions took an interest in this asset class.”

This publication provides analysis of every property market making it a must-have in any commercial real estate professional’s back pocket. To download the full report, go to the REALTOR® Store at www.realtor.org/store.

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