Does the Past Decade Indicate What’s to Come?

 “Low interest rates, a volatile stock market, expectations of an improving economy and a cyclical bottoming for commercial real estate fundamentals should drive investment activity and values higher.” This statement, not too far off from the current mood of the market, was the industry sentiment in 2002 as the United States began to recover from recession, the 9/11 tragedies and corporate scandals. Five years later, the composite index of commercial property values had soared 53%, an unprecedented and unsustainable trend driven by unusual – and eventually – damaging factors.

The investment market drivers for the past decade may provide some guidance as to what may unfold in the future. The underlying hope is for a return to fundamentals-based capital flows leading to less volatility and a more orderly creation of value in the markets. History tells us that markets are seldom orderly, so what is in store for investors over the next few years? Competition among capital sources in a low-yield environment led to dangerously lax underwriting standards across all assets, particularly in the U.S. real estate market. CRE sales volume nearly tripled from 2000 to 2007, pushing the overall price index up 60%. The Great Recession followed shortly thereafter, causing a 79% drop in sales volume and an estimated 40% drop in values on average from peak to trough. As a result, the lending pendulum swung too far to the extreme, shutting off credit to consumers and businesses all over the world. Broader availability of financing is needed to normalize the economy and real estate markets.

The threat of bubbles is still a major concern as the dramatic movement of capital in and out various assets continues. Recently, worries about the bond, gold and raw materials markets have dominated headlines, and as the tide between risk and opportunity ebbs and flows capital rotation could be radical at times. CRE is not immune to these flows and as it gains broader favor, prices will appreciate with, sometimes with extreme unevenness. Competitive and improving cash yields will become a major draw as will the advantage of real estate as an inflation hedge once the recovery kicks into gear. However, differentiation of pricing by quality and fundamentals-based rent growth projections among lenders and buyers are likely to remain part of the equation. Adding new supply will be more difficult and expensive in the next cycle, especially for the harder-hit segments: office and retail and assets located in secondary/tertiary locations  While this will not prevent mini bubbles, it should support the case for a rising but smoother value-trend line over the next 5 to 7 years.

Selective Exuberance or Another Bubble?

Investment sales are on pace to rise 55% by year’s end but buyer demand has been concentrated in the high-end of the market, with some assets received as many as 20 to 30 qualified offers. This has resulted in cap rates re-compressing by as much as 100 basis points from their highs in 2009.raising flags of another bubble. So far, this selective exuberance has been driven by best-of-class properties with stable tenant demand and prospects for strong rent growth in supply constrained markets. These investments require conservative LTV and DSC ratios and the typical spread between cap rates, locked-in interest rates and cost of equity capital have provided a compelling safety net. This is substantially different from the days of 80% or higher LTV ratios and minimal due diligence on underlying assets. The key qualifier, however, is “so far.”

Will further risk-taking create additional upward pressure on pricing and justify development, or has the market learned from the past? If cap rates continue to compress in the upper-end of the market and lenders relax their standards ahead of sustainable job growth, a mini-bubble would be the result. For long-term investors with a 5- to 7 year horizon, this should not be a major threat for stabilized assets. More likely, sales activity will increase in the next quality tier of assets, which have not captured as much buyer attention. Given the lingering caution among buyers and lenders, this class of property would still require tenant attraction/retention and low future supply-side risk. The buyer composition is also likely to include more private and opportunistic investors who are adjusting their yield expectations with realization that reasonably quality assets are unlikely to trade at distressed pricing. This will gradually bring a much-needed broadening of the CRE investment sales recovery, so far limited to top-tier assets.