Hessam Nadji

More clarity, low interest rates to propel CRE sales

Historically low interest rates, largely engineered by the Fed’s new phase of quantitative easing, bottoming of occupancy losses in most property sectors, an early recovery in the apartment sector and the historically wide spread between real estate cap rates and interest rates will spur more investment sales activity in 2011. The election results will likely move the political agenda more to the center, with likely compromises on key issues such as Bush-era tax breaks, spurring more economic activity by reducing uncertainty. In an extremely low-yield environment, investors’ appetite for higher returns should also expand, broadening next year’s commercial real estate investment activity.

How far have we come?
Commercial real estate sales volume will increase by an estimated 55% in 2010. This is an easy, yet encouraging comparison over 2009, a year defined by the most severe credit crunch in recent history, an economic crisis and severe uncertainty. These factors kept the vast majority of investors on the sidelines last year, resulting in a 53% drop in overall sales volume from 2008, and a 79% decline from the market peak of $501 billion in 2007. The 2007 level was an anomaly and not the industry bench mark against which normal sales activity should be measured. Nevertheless, this year’s expected $168 billion in sales is still 41% below a more normalized bench mark of $287 billion, which resembles the more balanced year of 2004.

Who is buying and why?
The majority of recent investment activity has reflected a flight-to-safety trend with concentration in larger, top-tier assets located in primary markets. Institutions and REITs, many of which were in survival and recapitalization mode last year are back in earnest, but have had a low risk tolerance. The dollar volume of sales for transactions valued at $20 million or more is up 110% over last year in the four major property types. The dollar volume of sales valued between $10 and $20 million is up 36.5%. This segment is driven by larger private and hybrid investors whose capital sources often include institutions and foreign funds. Not surprisingly, cap rates in these segments of the market are down by 100 basis points to 125 basis points over last year. At the same time, smaller, private investor-dominated sales below $10 million are only up 8%, mainly because smaller property sales did not drop off as dramatically last year. Single-tenant net leased properties and small apartments particularly benefited from available financing from the few institutions lending money during the downturn.

Lower-quality properties in secondary and tertiary markets have experienced the biggest decline in values, and continue to face challenges due to a lack of investor demand and available financing. The volume of distressed sales processed into the private market by lenders, although short of expectations, has been concentrated in this category. This is further pressuring values and creating a highly bifurcated investment market across all major sectors, particularly in office and apartment sales.

Why are top-quality assets trading at a premium when the economy is still weak? And can sales activity expand beyond this category?
Investors are paying a premium to acquire top-tier assets, but have focused on buying in supply-constrained submarkets that will likely generate out-sized rent growth during the recovery. Premium-priced acquisitions that could face competition from new supply will clearly be riskier, and investors should take caution in their underwriting. Institutional and major private investors typically with a 5-year to 7-year hold horizon have more emphasis on risk-adjusted, cash-flow yields than current terminal cap rates. So far, this has proven to be a solid strategy that will likely trickle through a broader segment in the market over the next 12 months to 18 months for several reasons:

• The U.S. economy has slowed and will remain sluggish for the next six months, but another recession seems unlikely based on the latest indicators. More capital will leave the sidelines seeking positions in the market place.

• The spread between interest rates, corporate bond yields and CRE will drive investor demand. The Fed’s QE2 (Quantitative Easing 2) has already pushed interest rates incredibly low. This will encourage more risk taking, spur exports by keeping the dollar down and generally provide a shot in the arm to the stagnant U.S. economy. This short-term form of stimuli, however, would have to be removed from the system quickly to prevent currency wars and inflation. The window of time for taking advantage of today’s extremely low interest rates maybe limited as a result.

• The froth in the upper-end of the market and lenders’ ongoing strategy not to fire sale assets will drive investors to move down the quality chain. That is not say to caution will be or should be thrown out, but investors should view the risk-reward of the next tier of acquisitions more favorably. Early movers in this phase of the recovery can take advantage of larger price corrections and emerge as the next group of winners.

Hessam Nadji is managing director, research and advisory services, for Marcus & Millichap Real Estate Investment Services. Contact him at [email protected] or (925) 953-1700.