Let's Not Forget the Lessons Learned

By Sule Aygoren Carranza

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After a dismal couple of years, sales activity picked up significantly in 2010, with volume surging to 2007 levels at year-end. The pace of closings didn’t continue as earnestly into 2011, though investment levels look promising this year—in fact, January 2011 saw a 50% increase over the prior year, according to Real Capital Analytics.

There are several drivers behind the bullish transactions market, investor appetite and lack of alternative investment opportunities among the primary ones. Investors of all stripes, particularly institutional players and private investors, are sick of waiting it out and have allocated billions of dollars to real estate. Capital-flush public REITs have also stepped up to the negotiating table and are scouring the market for deals.

Of course, everyone’s going after the same thing: high-quality product in top-tier markets. Given the sectors’ positive prospects, multifamily assets and hotels have been highly sought after over the past several quarters. But lately, sales of office and retail properties have seen a pickup in activity as well.

After posting $29 billion in December, sales volume hit $10 billion in January, the most recent figures available from RCA. Pricing is on the rise across most property sectors, led by premier assets in high barrier-to-entry markets. The top six markets in Moody’s/REAL CPPI saw pricing rise 7% between November and December, and a whopping 32% from a year earlier. And cap rates certainly aren’t at the record lows of the halcyon days, but they’re lower than they were a year ago for all core property types, currently hovering in the mid-7% range.

The cap rate declines and pricing increases are, of course, mainly a product of too much capital going after limited supply, with a dash of low interest rates thrown in.

Investor interest in commercial property is understandable: real estate is a great hedge against inflation, yields here are better than most mainstream investments, interest rates remain relatively low and, for the most part, well-leased assets offer a steady income stream. But one has to wonder whether the market might be getting a little too aggressive, given this stage of the cycle.

For one, the economy is still uncertain. Sure, job losses appear to be on the decline and business—and dare I say, consumer—confidence is gradually rising. Still, the average American household is still feeling the hit of the recession—unemployment is above 9% and foreclosures are increasing—and any true, tangible sign of a recovery is still a long way off.

In commercial property, tenants are no longer dropping out like flies due to bankruptcies and cutbacks, but they aren’t expanding much, either. In fact, the retail space continues to see losses, Borders being the latest to pull out of the market. On the office side, landlords may not be offering huge concessions anymore, but they haven’t got much pricing power, either. And it’s not like there are so many tenants shopping for space anyway.

Eventually, some of those holding assets will be enticed—or, depending on their financial situation, forced—to sell, increasing the pool of offerings in the market. And ultimately, would-be buyers will get sick of the slim pickings and high prices of the trophy assets and tier-one markets and will venture into lesser-quality product in secondary and tertiary markets.

But until that happens—if it happens—I’ll be keeping a close watch on the capital in the market and the deals that are taking place. My main concern is that investors will begin to go after some product in certain markets too aggressively, driving pricing up before fundamentals catch up, creating more bubbles. Hopefully the financing market will serve to temper some of that enthusiasm, but I wouldn’t be surprised if they feed it, either.

One thing is clear, though: with all the capital in the market, the next several months should prove to be very interesting in terms of dealmaking.

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