Focus and Discipline for the Road Ahead

NEW YORK CITY—As previously reported on GlobeSt.com, the Urban Land Institute's consensus forecast through 2017 calls for increases in investment sales volume to level near the previous peak, and also for CMBS issuance to reach $150 billion by the end of '17. And Kevin Thorpe, chief economist for DTZ, says that in the absence of a black swan, “US capital markets will shatter records this year, both in terms of volume and pricing.” Yet along with the expectation of continued growth, there have been a number of expressions of clear-eyed realism lately.

“The markets are frothy right now,” Ken Perry, president and CEO of the Swig Co., told GlobeSt.com in a video interview at the recent RealShare National Investment and Finance conference. “You have to be very cautious. It's a good time to be an investor, depending on where you want to go and where your strategy is. It's very important to be focused and disciplined.”

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A Towers Watson report earlier this month on global alternative investments sounds a similar theme. In many ways, Towers Watson says of the real estate sector, “it feels like 2007. Double digit returns, transaction volumes at multi-year highs, yields reaching multi-year lows, debt costs at ever lower levels on higher loan-to-value terms, regional (non-gateway) locations seeing increased investor interest, speculative development starting to re-emerge and fund raising breaking records in terms of speed and size.”

Nonetheless, the company notes that unlike what we saw in '07, “the property yield spread relative to long-term government bonds shows a healthy spread, which provides some investor comfort.” However, the report notes that despite real estate looking attractive relative to bonds, “we believe investors should be more patient and selective when investing new real estate allocations at the current time. We have seen growing interest in co-investments, joint ventures and direct deals as investor aim to have more control and visibility on both assets and pricing. At higher points in the market cycle, this visibility appears valuable.”

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Other recent reports have issued stronger caveats. MetLife Real Estate Investors, while confident that occupier demand will continue to outpace supply in the near term, also points to “an aging economic cycle,” which in turn implies “an aging real estate cycle.” And a Situs RERC survey notes that investors' ranking of investment conditions has shown a number of sectors slip down a few notches compared to a year ago.

To Kenneth Riggs, president of Situs RERC, this is likely the first key sign among survey respondents about the future performance of CRE from a price vs. value perspective. Investors perceive that prices have peaked relative to the underlying valuations, he says, and commercial real estate will be challenged to maintain these price levels going forward, given the future market for cap rates and prices.

As pricing has increased—in some instances it has surpassed the '07 peak—cap rates have narrowed. Whether they'll continue to do so is uncertain: Akerman's 2015 Real Estate Survey finds that in all but multifamily, more respondents believe cap rates will stay the same this year than say they'll compress.  

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Earlier in the recovery, says TIAA-CREF, “total return was driven more by cap rate compression as illustrated in the relatively weaker NOI growth and strong total returns, especially in 2010 and 2011. Looking forward, the annual benefit of cap rate compression is expected to continue to wane and NOI growth is anticipated to become the primary driver of total return performance.”

However, “strong total returns and the rising property values embedded in them have resulted in lower yields,” according to a recent TIAA-CREF report. “Recognizing that Treasury yields have been hovering around the 2% mark, today's cap rate spreads support the conclusion that current property pricing is not only sustainable, but offers the potential for some further yield compression.”

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