These trends reflect a more cautious outlook on behalf of private investors who in recent quarters have become concerned about the degree of price appreciation over the past few years, historically low cap rates and the prospects of a slowing economy. On the other hand, institutional investors, which have structurally shifted toward raising their real estate allocations, are concentrating their acquisition activity on larger, top-tier properties in primary markets. Another factor behind the increase in larger property sales is the privatization of large (major) REITs, mergers and the spin-off sales that have followed them. Lastly, larger private investors who have built up significant equity over the past few years are consolidating their equity out of multiple, smaller properties, to larger, more institutional properties. Many of these private investors are baby boomers who are getting closer to retirement and their priority is shifting toward wealth preservation and income.

The common theme throughout the majority of the marketplace is strength in valuation. While the rate of appreciation for smaller properties has slowed significantly, pricing pressures and cap rate compression are common for top-tier assets. Class B and C properties are experiencing more of a pricing gap and have seen a moderate increase in cap rates as a result, particularly in secondary and tertiary markets. Improving property fundamentals in most sectors, balanced new construction and healthy rent growth are supporting values and will continue to do so. As prices stabilize and net operating incomes improve over the next 12 to 24 months, cap rates will move up moderately but are unlikely to return to their long-term averages in the foreseeable future, since there is no cause for deep discounting of real estate prices.

In a low-yield environment, investors are clearly shifting toward emerging property types and value-add opportunities. This is leading many investors to seek opportunities in the office and industrial sectors. Although the bulk of recovery in office market fundamentals is in the past, the sector continues to offer comparatively strong potential for near-term revenue growth through rent increases and further cutbacks in concessions. Cap rates for office properties continued to decline in early 2007 but are expected to level off as the year progresses. Major coastal markets, such as New York, Los Angeles and San Francisco, could prove to be the exception. Despite rapid price appreciation in recent years, office property replacement costs in these markets are still estimated to be 35% to 45% greater than sales prices, and rapid rent growth has been recorded so far this year. While the outlook for the office market remains optimistic, investors would be wise to keep a close watch on the development pipeline. In markets that registered the greatest declines in homebuilding activity, a downward correction in land prices and labor/construction costs could prompt commercial developers to commence new projects in the near term.

Apartment fundamentals began to show signs of softening late last year, attributable in large part to the growing shadow-rental market. While the market recorded another uptick in vacancy in the first quarter of 2007, the increase was modest and typical for the early months of the year. There is, however, little doubt that the oversupplied condo market will lead to rising vacancy in a handful of markets as 2007 progresses, but long-term renter-demand drivers remain firmly in place. Cap rates for true value-add properties and luxury apartments dipped slightly during the early part of the year as prices continued to rise, though cap rates for smaller, lower-quality assets have moved upward. While competition for best-of-class assets is expected to remain at high levels, smaller, private buyers are more selective and expecting higher returns to compensate for the perceived increase in risk created by economic uncertainty. Overall, given the depth of apartment demand and the availability of capital in the market, however, a major movement in cap rates is not in the cards.

Turmoil in the residential subprime mortgage market is a double-edged sword for the commercial real estate market. On one hand, foreclosure activity is expected to impact consumer spending, which has been a key driver of economic growth and the retail market's stability in recent years. Retail development has been based primarily on tenant demand, but slower spending is likely to result in moderate increases in retail vacancy this year. Competition for top-tier retail properties is expected to remain elevated throughout 2007 as major retail investors continue to upgrade their portfolios. The limited availability of large, high-quality retail properties has actually driven many large owners to development. Strip center properties and lower-quality, single-tenant assets, however, are facing more scrutiny in today's market, which is likely to result in slight increases in cap rates. During the early months of 2007, for-sale retail inventory of strip centers increased significantly, which combined with a more discerning buyer pool could result in more upward pressure on cap rates by year's end.

The flipside of the unraveling subprime mortgage market is that tighter lending restrictions are expected to prohibit many would-be homebuyers from purchasing homes over the next few years, which bodes well for apartment owners. Mortgage foreclosures are also rising, which will also result in a growing number of former homeowners returning to the rental market.

While there are certainly factors that commercial real estate investors should monitor closely this year, the overall outlook remains very positive. Interest rates are still low by historical standards, and there is more capital available in the market today than ever before. Long-term interest rates have proven to be highly susceptible to rapid fluctuation in recent months, as the bond market's reaction to economic indicators and foreign fund flows has been swift. However, the economic slowdown and increased risk factor due to the housing cycle point to flat or lower interest rates, as opposed to any major factor driving interest rates substantially higher. Investors who wait on the sidelines this year for a major correction in prices, or those who do not take the time today to evaluate current holdings based on return on equity, stand the greatest chances of missing out on significant opportunity.

Harvey E. Green is the president and CEO of Encino, CA-based Marcus & Millichap Real Estate Investment Services. The views expressed in this article are the author's own.