CRE Sales Hold Steady Amid Capital Markets Turbulence

Since the onset of the economic slowdown and capital markets volatility in the past two months, multiple readings have turned flat to negative, the equity markets have been on a wild ride and not much has surfaced from the political process in Europe or the United States to reduce fear or uncertainty. The European Union’s recent decision to expand its bailout initially met limited optimism by the markets.  Through this period, my overriding theme for commercial real estate investors has been to be realistic about short-term risks, which have risen significantly, but not to lose sight of the market’s long-term opportunities. Generation-low interest rates, the notion that the Great Recession 2.0 is highly unlikely and the expectation that the U.S. economy will eventually reclaim sustainable, if unspectacular, average economic growth, without a big surge, form the case for commercial real estate as an attractive investment in this environment. Let’s not forget plummeting new construction numbers, which are far less likely to rebound before demand improves and stays strong for a few years as another important factor. 

Capital continues to flow into commercial real estate and the first half of 2011 reflected rising momentum as financing became more available, values stabilized or showed appreciation and property fundamentals improved. Commercial property sales surged to more than $100 billion in the first six months of this year, compared to $64 billion for the same period in 2010. This year’s first half sales volume was nearly the same as the entire year in 2009. As has been widely publicized, the theme of this recovery has been the institutional buying surge. In the 12 months ending June 30, sales volume of properties valued at $20 million and more surged nearly 130% on a year-over-year basis compared to an overall increase of 36%. Mid-market sales volume – properties valued between $10 million and $20 million – increased by 57%, reflecting resurgence in activity among larger private investors, and to some extent institutional investors’ push down into smaller but high-quality assets. Sales volume of smaller transactions – those transactions valued between $1 million and $10 million and dominated by private investors and high-net worth individuals – surged 25% during the same period. This is a critical indicator for market activity since this segment comprises more than 85% of all commercial property sales in the U.S.

The onset of the recent financial market turmoil has selectively impacted CRE sales, with larger property sales experiencing a slowdown while the rest of the investment market place marches on at a relatively steady pace.  Based on preliminary results, sales volume in the $20 million-plus segment was down 25% in the July-August period compared to the monthly average through the first half of 2011.  This was partially due to increased buyer caution given the recent price surge and cap rate re-compression in this category. Lender caution was also a factor as was the disruption in the CMBS recovery. The upper-end of the market, which has been the most active, is vulnerable to further slowing, especially since the recent decline in the stock market caused an artificial escalation of real estate asset under holdings, which may negatively impact institutional allocations to commercial real estate. However, sales activity should not experience a major set back unless fears of contagion from European banks materialize and cause a more serious shake up in global capital markets.

As is always the case, the private investor segment is not only driven by investment decisions that fuel trades, but the natural drivers of estate planning, death, divorce and partnership break-ups and formations. As long as a baseline level of financing remains open, even with conservative underwriting, sub $15 million properties will continue to actively trade.  One of the factors limiting the rise in smaller property sales is the slow-down in 1031 exchanges which are still hampered by valuation and investor caution.

Overall, there is no shortage of domestic and foreign capital sources searching for yield who continue to view commercial real estate favorably. At the same time, life insurance companies, stable commercial banks as well as Freddie Mac and Fannie Mae are actively lending. Market pricing has been reset, investors have adjusted to normalized loan-to-value requirements, buyers and sellers are closer in their definition of fair value and stabilized and/or improved prices are motivating many sellers to bring inventory to market that they could not sell over the past two years. 

Stable Class B properties and healthier secondary markets should continue to see improvement in capital flows thanks to higher yields and acceptable risk profiles. 

However, recent developments and financial market fragility is likely to reinforce the flight to safety, keeping lenders and buyers cautious on lower quality B- and C assets and tertiary markets. The recent downgrade of U.S. banks may also cause more reluctance by lenders to provide risky commercial property loans, particularly construction and renovation-related financing. Ironically, this will further limit new supply and aid the gradual recovery in the commercial property sector. We are still vulnerable to further and more serious financial market disruptions and unexpected shocks, but the indicators point to an active investment sales market.

Hessam Nadji is senior vice president and managing director of Institutional Property Advisors. Contact him at hessam.nadji@ipausa.com.