CRE Investment Market Defies Economic Headwinds

Last year’s robust recovery in commercial real estate sales volume won’t be repeated but the movement toward more normalized trading activity is on track. Several factors skew the numbers behind last year’s recovery and this year’s growth. First, last year’s near doubling of sales volume to $160 billion in the four major property types – apartment, industrial, office and retail – came off the extremely low sales volume of 2009. Second, the recovery is still being driven by a top-down movement of capital with institutional and major private investors dominating the market with $20 million-plus acquisitions, usually of higher quality properties in primary markets.

In the past 12 months, the dollar volume of $20 million plus transactions has jumped 160%, compared to a 35% jump in the $1 million to $20 million segment. Public REITs, pension funds and large national private investors remain dominant buyers, particularly public REITs whose low cost of capital and rich valuations have positioned them well to lead development and acquisition. Trading activity among smaller private investors has lagged in the rate of improvement but this is mostly a result of a smaller decline in activity during the financial crisis.

Overall sales volume is on track to increase by 20% to 30% over 2010 to $245 billion.  This is similar to the 2003-2004 levels, which provide a good benchmark for a generally normal trading environment. This level of activity is fueled by low interest rates, improved availability of financing, a sense that pricing has generally bottomed, expectations that at least a moderately paced economic recovery will endure beyond the current slowdown, little new supply coming online in most product types over the next two to three years and competitive overall yields compared to alternative investments, with the exception of ultra-low cap rate trophy assets.

How can investors benefit from the current and future trading patterns? A few trends are worth monitoring and leveraging into a successful buy/sell strategy. Institutional capital is moving down to smaller but quality assets in primary markets as the picking gets thin and competition intensifies for larger core properties in the top 10 metros. Interest in relatively healthy secondary markets has already picked up among private and institutional investors, so these markets will start to show increased sales activity and appreciation. Moderate value-add investments, well short of full-scale renovation or re-use are back as a strategy among all types of buyers chasing better yields. These investments can be very effective as long as the asset and the corresponding rents don’t overshoot what the market will bear. 

As top-quality, trophy inventory becomes scarcer, look for more Class B and B- assets to arrive on the market. Many of the owners who held on through the downturn can now achieve higher valuations, thanks to the tremendous volume of capital looking to get back into commercial real estate. For those who have held on for more than five-to-seven years and did not over-leverage, low return on equity can now be addressed by exchanging and/or redeploying into more opportunistic sectors, markets and situations. Many investors who can now sell closer to target prices are also opting for steady yields and low management requirements provided by single-tenant net-lease assets.

The recovery is not all smooth sailing. Lending standards are still tight and will remain so for the foreseeable future. Many assets are still under water and headed for troubled status in need of fresh equity injection and restructuring, which usually does not bode well for current owners. Tertiary markets and/or Class C assets will have a hard time attracting buyers and lenders, and last but not least, caution persists, given the economic volatility, so pricing must be realistic. These factors will continue to skew the recovery toward better quality assets but the gradual broadening of sales will gain momentum in the second half of this year, thanks to the search for yield.

Hessam Nadji is managing director, research and advisory services, for Marcus & Millichap Real Estate Investment Services. Contact him at hessam.nadji@marcusmillichap.com.