What to Consider When Values Start Flat-Lining in 2018

IRVINE, CA—When commercial real estate values start flat-lining in 2018—which he predicts they will—watch what happens with interest rates and real estate fundamentals like vacancies and rents that drive NOI, Ten-X's Peter Muoio tells Globest.com. As we recently reported, the major commercial property sectors have seen mixed results when it comes to pricing growth, with three of the five posting modest gains in October from the previous month, according to the firm's Commercial Real Estate Nowcast. Apartments once again led the winners' parade, while retail and hotels fared less well in October.

We spoke exclusively with Muoio about CRE valuations and when we might begin to see them flat-lining.

GlobeSt.com: Although CRE valuations are still rising, the rate of increase is slowing. At what point do you believe we will begin to see some sectors flat-lining in value?
Muoio: In our view, valuations will start flat-lining in 2018, though there will be significant differences across segments and markets. There are two keys points to consider when values start flat-lining: what happens with interest rates and what happens with real estate fundamentals like vacancies and rents that drive net operating incomes. The consensus is that rates will rise in the US in the coming years, but the consensus has been wrong before. Nevertheless, the US economy has sustained growth amid many headwinds, and an increasingly robust labor market is driving growth. As a result, rates are likely to rise in coming years, and this will exert upward pressure on cap rates. As for NOI growth, the outlook varies a lot by segment and market, but we are definitely later in the cycle and gains may start to slow.

GlobeSt.com: Do you believe valuations will decrease at some point in the future? If so, when and why?
Muoio: In our projections, we predict an economic downturn in 2019-2020. We chose this period because by then the economic cycle would be exactly twice the average age of cycles in the US since World War II. If this were to occur earlier, we could expect broad-based valuation declines prior to that time period.

GlobeSt.com: Which sector or sectors will be the first to feel a flat-lining or decrease in values?
Muoio: The apartment and hotel segment are the most vulnerable. This reflects two things. First, these sectors are much further along in their cycle than the other property segments, and development has picked up significantly, increasing supply-side risk to fundamentals, with or without a recession. Second, both apartment and hotel segments have the shortest lease terms, so they feel the impact of economic changes faster than the other property segments. Retail may also be vulnerable because the segment continues to battle headwinds from the shift in consumer purchasing patterns—both the shift to online retail and the shift toward “experiential” spending.

GlobeSt.com: What else should our readers take away from your October Nowcast?
Muoio: Despite a lot of questions about where we are in the cycle, most CRE segment values have continued to increase and have shaken off the weakness displayed earlier this year. The divergence across property segments in the Ten-X Nowcasts also show that investors are savvy to the differing dynamics across property segments. Finally, the general increase in CRE prices is happening amid a drop-off in transaction flow, suggesting that in the current environment, the “better” deals are closing.

IRVINE, CA—When commercial real estate values start flat-lining in 2018—which he predicts they will—watch what happens with interest rates and real estate fundamentals like vacancies and rents that drive NOI, Ten-X's Peter Muoio tells Globest.com. As we recently reported, the major commercial property sectors have seen mixed results when it comes to pricing growth, with three of the five posting modest gains in October from the previous month, according to the firm's Commercial Real Estate Nowcast. Apartments once again led the winners' parade, while retail and hotels fared less well in October.

We spoke exclusively with Muoio about CRE valuations and when we might begin to see them flat-lining.

GlobeSt.com: Although CRE valuations are still rising, the rate of increase is slowing. At what point do you believe we will begin to see some sectors flat-lining in value?
Muoio: In our view, valuations will start flat-lining in 2018, though there will be significant differences across segments and markets. There are two keys points to consider when values start flat-lining: what happens with interest rates and what happens with real estate fundamentals like vacancies and rents that drive net operating incomes. The consensus is that rates will rise in the US in the coming years, but the consensus has been wrong before. Nevertheless, the US economy has sustained growth amid many headwinds, and an increasingly robust labor market is driving growth. As a result, rates are likely to rise in coming years, and this will exert upward pressure on cap rates. As for NOI growth, the outlook varies a lot by segment and market, but we are definitely later in the cycle and gains may start to slow.

GlobeSt.com: Do you believe valuations will decrease at some point in the future? If so, when and why?
Muoio: In our projections, we predict an economic downturn in 2019-2020. We chose this period because by then the economic cycle would be exactly twice the average age of cycles in the US since World War II. If this were to occur earlier, we could expect broad-based valuation declines prior to that time period.

GlobeSt.com: Which sector or sectors will be the first to feel a flat-lining or decrease in values?
Muoio: The apartment and hotel segment are the most vulnerable. This reflects two things. First, these sectors are much further along in their cycle than the other property segments, and development has picked up significantly, increasing supply-side risk to fundamentals, with or without a recession. Second, both apartment and hotel segments have the shortest lease terms, so they feel the impact of economic changes faster than the other property segments. Retail may also be vulnerable because the segment continues to battle headwinds from the shift in consumer purchasing patterns—both the shift to online retail and the shift toward “experiential” spending.

GlobeSt.com: What else should our readers take away from your October Nowcast?
Muoio: Despite a lot of questions about where we are in the cycle, most CRE segment values have continued to increase and have shaken off the weakness displayed earlier this year. The divergence across property segments in the Ten-X Nowcasts also show that investors are savvy to the differing dynamics across property segments. Finally, the general increase in CRE prices is happening amid a drop-off in transaction flow, suggesting that in the current environment, the “better” deals are closing.