Bob Bach
The commercial real estate investment sector has seen a strong increase in activity over the past year. Transaction dollar volume is up 116 percent for deals valued at $5 million and more through the first six months of 2011, compared with the first six months of 2010, according to Real Capital Analytics. Moreover, nearly every type of buyer, including publicly traded REITs, institutions and private investors, are taking part. Low interest rates and an increase in leasing activity, particularly for apartments, have stoked activity. Institutional-grade properties are seeing more buyers than sellers. Debt and equity capital continues to focus on core assets in primary, supply-constrained markets, or in other words, the best properties in the safest markets. However, investors suffering from “yield fatigue” have been willing to assume more risk this year, purchasing Class B+ properties or those located in secondary and tertiary markets for example, particularly if they can get them at a bargain. Property values in a handful of 24-hour downtowns have rebounded and are nearing pre-recession levels. Prices in smaller CBDs and most suburban areas remain well below their prior peaks, and in some cases are still mired near their cyclical low points.
A look at commercial sales in the past decade. 2011's activity year-to-date has been the strongest since 2008, with the strongest showing in the second quarter since 2007.
Average capitalization rates are generally in the 7 to 8 percent range for all property types except apartments, which average 6 to 7 percent. Over the past year, cap rates have declined 30 to 100 basis points depending on the property type. Much of that decline is due to the mix of properties being sold, specifically core assets that are pushing average cap rates lower. As more sub-core properties are sold, average cap rates are expected to stabilize, if not begin to increase again, reflecting a broader range of asset quality in the sales mix.
The most popular assets have been stabilized, core assets located in the heart of a city or its primary districts. In San Francisco the South of Market district is hottest, West Los Angeles is popular, including Hollywood, and in New York it’s the Midtown area. Investors often don’t even look at properties in the surrounding areas like Walnut Creek, Calif., the Inland Empire in Southern California or New York’s suburbs. Many of these suburban markets are flooded with vacancy and have yet to begin adding jobs in meaningful numbers. In terms of product type, demand for apartments, hotels and industrial properties is very strong in core markets where there appears to be very aggressive pricing. Investors want the best of the best properties and will bid prices upward to get them.
Breaking Down the Market By Investor Type
Over the past four quarters, publicly traded REITs have been big net buyers as investors have poured money into these funds. Non-traded REITs have also been very active and attracted large amounts of capital. Institutional and private investors have been big net sellers, but for different reasons. Institutions such as pension funds and insurance companies, which invest heavily in core properties, have been able to take advantage of strong demand for these assets. For them, it has been a seller’s market. While some private investors have benefited from these same dynamics, they often mix riskier assets into their portfolios. There is some forced selling occurring, or perhaps they have made the decision to liquidate and redeploy their capital in more promising sectors.
More recently, institutional investors have started becoming net buyers in order to deploy capital, which is expected to continue in the near future. These types of investors often have different funds to choose from and look to harvest their properties and invest in new ones to help turn profits. There has been an increase in year-over-year sales velocity, somewhat due to the pent up demand or the need to sell after the past few years. The normal harvesting cycle was disrupted and it became time to start once more.
Private investors are often working through leverage and need to get out of debt. Without the financial strength that institutions enjoy, private owners don’t generally have the same resources to fall back on. For some, it also depends on when they got into the market, as owners that purchased at the end of the economic downturn after the dot-com era in the early 2000s are in a much better position to sell today in terms of property value than an owner that purchased their property at the peak of the market in 2007.
Banks are starting to show increased signs of interest in commercial real estate investments versus other asset classes due to the market improving and demand moving upward. Banks are expected to continue to be more aggressive with the exception of smaller banks that continue to work through their backlog of REO assets. Pricing is also expected to increase gradually as more capital is poured into real estate.
Despite increasing demand for commercial properties, investors are plugging more conservative assumptions of rent growth and price appreciation into their pro forma calculations. Whereas a 5 percent vacancy factor was deemed adequate in the bubble years, investors now use 6 to 7 percent vacancy factors. With the exception of apartments, leasing markets remain sluggish and rent growth has been confined to a few submarkets and property types, such as “creative” space in tech hubs like the Bay Area’s Palo Alto and South of Market submarkets and Class A office buildings in Midtown Manhattan. With economic growth slowing to a crawl this year and financial markets taking a tumble, these conservative assumptions seem more than justified.
In the absence of another recession — which still looks like a reasonable assumption despite the recent financial turmoil — commercial real estate is expected to continue to improve on both the leasing and investment sides. Leasing was unexpectedly strong during the second quarter, which could be a delayed reaction to stronger economic growth late last year or a sign that businesses are finally becoming more willing to make long-term plans.
— Bob Bach is the senior vice president and chief economist for Grubb & Ellis Company.