IRVINE, CA—Deal activity may have been slowed by the looming specter of tax reform, which prompted investors to delay transaction closings until the new, advantageous legislation took effect in 2018, according to Ten-X Commercial. The firm’s latest Commercial Real Estate Volume & Pricing Trends report shows that CRE transaction volume declined to $117.4 billion in Q4; according to Real Capital Analytics, this amount represents a 0.5% decline from the prior quarter.
Interestingly, the decline can is connected to one property sector: industrial. Coming after two quarters of growth, the minor quarter-on-quarter decline is attributable to a $6.7 billion drop in deal volume in the industrial sector. Compared to the year-ago period, fourth-quarter investment activity plunged by 13.2%, while the annual figured dropped 6.9% to $445.2 billion.
“Uncertainty around tax-reform-related policy undeniably weighed on deal volume late last year, but the legislation that eventually passed is expected to be beneficial to the real estate industry,” said Peter Muoio, Ten-X’s chief economist, in a prepared statement.
Muoio added that the main question on everyone’s minds now is whether the delayed closings and optimism about the new tax regime will be enough to offset other headwinds and fuel deal-volume growth in the first quarter of 2018 and beyond. “The run-up in interest rates since the start of the year is a potential downdraft on deal closings as financing costs increase and cap rate expectations change.”
Muoio tells GlobeSt.com it is unlikely we will see a bounceback in volume in the first quarter of 2018. “The sharp rise in the 10 year Treasury rate appears to be having the same kind of impact the jump in treasuries did after the election in 2016. Buyers are seeing their financing costs rise from when they first considered deals and will need to adjust to the new situation. ”
He adds that the increase in rates and the likelihood of further jumps now that inflation appears to be percolating will prompt a re-think of exit cap rates down the road. “ Just yesterday, the new Federal Reserve Chairman Jerome Powell commented that in his view the economy’s prospects have brightened, and Treasury rates rose in response. Deal volume was down in January, and this backdrop makes a strong pop in the remainder of the quarter improbable.”
The changing of the guard at the Federal Reserve, with Powell taking over as Fed chairman from Janet Yellen, is yet another source of uncertainty for buyers and sellers, says Ten-X. Powell is expected to follow a similar path as his predecessor, investors will observe his initial actions closely to see if interest rate expectations remain in place.
In addition, persistent concern about the age of the US economic expansion, which is now in its 104th month, also hampered deal flow, Ten-X reports. This concern has created a pricing gap between sellers and the many buyers who are wary about purchasing property at tight cap rates so late in the real estate cycle.
Fourth-quarter deal volume continued to recover from a downturn at the beginning of 2017, but remains far off its cyclical peak. However, the overall loss was diluted by gains in the office and apartment sectors, in which deal volumes grew $6.2 billion and $1.4 billion from the prior quarter, respectively. As a result, overall deal volume was down just 0.5% from Q3.
Unlike industrial, the apartment sector’s share of total deal volume rose for the third consecutive quarter, reaching 37.1%, the report continues. This was its highest level on record and more than 800 bps above its 1- year average. The industrial sector saw the sharpest quarterly drop in deal volume share, down 560 bps, but that figure was on par with its 10-year average. After rising 550 bps in Q4, the office sector’s share of deal volume is at 30.6%
As we recently reported, Ten-X has also revealed other trends, including continued property-pricing weakness into 2018, with property valuations now up just 0.4% year-over-year as of February. Pricing in three of the five major property segments—including apartments and retail—increased in February, while office and hotel both declined. Interestingly, despite the decline in transaction volume for industrial, prices for the sector rose by 1%, reversing a January decline and narrowing the segment’s year-over-year pricing decline to 3.3%. The strengthening of the industrial economy in recent months has given investors renewed confidence that demand will continue, says Ten-X. Still, threats about tariffs and other trade barriers remain a risk for this segment.
Also, risk premiums are holding fast despite a slight uptick in interest rates, and cap rates across the sectors are below the 10-year average, with hotel holding the smallest gap.