by Kevin Maggiacomo, President, Sperry Van Ness International
As a storied 2010 comes to a close, I thought it a good time to offer my observations on the 12 months past, and to present my outlook for the economy and the commercial real estate market for the year ahead. Before I do, however, I would be remiss if I did not thank the Sperry Van Ness clients, Advisors, staff, and fellow brokers for their contributions to our strong year. I know that I speak for all SVN Advisors and staff when I wish you a safe holiday season and a prosperous New Year.
A Strong Close to 2010
Following two years of unprecedented upheaval, commercial real estate market conditions have improved markedly over the course of 2010. In the final days of December, Real Capital Analytics reports that the rush to bring deals to closing has pushed national transaction volume for the year past the $100 billion milestone, roughly doubling the market’s tally for 2009. This improvement in property sales reflects investor confidence in the long-term prospects for our industry as well as improvements, though sometimes modest, in supporting measures of economic and job market activity.
Coinciding with rising sales volume, broad measures of property prices have also firmed in 2010. Over the last three quarters, cap rates have fallen for virtually all property types. The gulf in pricing expectations that separated buyers and sellers in 2009 has narrowed, closing the “bid-ask” spread and allowing more parties to come to agreement. More confident in market valuations than during the depths of the recession, lenders have shown increasing eagerness to make loans for high quality property sales in recent months. While many banks are drawing down their commercial real estate portfolios, the CMBS pipeline is now reestablishing itself with roughly $15 billion of securitization projected for the first quarter of the New Year…a positive combination of events, indeed.
Imbalances in the Recovery
The overarching trends show an industry on a sustainable path of recovery. But as with any recovery that is not backed by a robust economy, the last year’s gains in commercial real estate investment activity and pricing have been uneven. Similarly, mortgage-financing terms have improved in the strongest investment markets while credit too often remained constrained elsewhere. Our team is acutely aware that the headline statistics of national sales activity do not properly convey these differences across our broad array of markets.
For much of the last year, the weight of institutional investor and lender interest has favored larger deals in a small group of coastal markets. Capital inflows to these markets have been unusually concentrated, pushing prices higher. According to the Moody’s/REAL Commercial Property Price Index, based on data from Real Capital Analytics, property prices have come off their lows. In the top three markets – New York City, Washington, DC, and San Francisco – they have done much more than that, rising 38 percent since 2009. As competition for trophy assets in these markets has intensified in recent months, a handful of record-setting deals have been added to the rolls. While that is welcome evidence of the market’s improving vigor, gains in the $500 thousand to $5 million segment of the market have lagged trends for larger properties in 2010, as has investor appetite for assets in non-primary markets. This, however, is quickly changing, and secondary and tertiary markets are back on the radar screens of opportunistic investors.
At the year’s close, the transaction record shows clearly that greater momentum is building in a wider range of markets and for a more diverse pool of properties than even just a few months ago. It is with this in mind that I offer some thoughts on the outlook for 2010:
The Economy
At this time last year, I described a scenario of measured growth in 2010, characterized by slow but sustained expansion in economic activity and an eventual return to business hiring. Consistent with these projections, the economy has expanded at a modest pace over the last year. Regrettably, the expansion has been insufficient to dent our national unemployment challenge. Barring any unexpected shocks, such as that which might result from a serious deterioration of sovereign debt conditions in Europe, the outlook for 2011 is brighter. The consensus among economists and industry leaders points to a much-needed acceleration in growth in the coming quarters, supported by the extension of tax cuts and the temporary payroll tax holiday. Consumer and business confidence has improved as well, benefiting retail spending and business investment and inventory levels.
While job growth has been flat out disappointing, leaving too many American families out of work this holiday season, employment has stabilized tremendously over the last year. Key to the stabilization of commercial real estate fundamentals, employers created almost one million net new jobs in 2010. In 2009, in contrast, employers cut nearly five million jobs. While current employment trends fall far short of healthy levels, the return to even modest job growth has ended the freefall in property rents and occupancy levels that has undermined buyer confidence, sense of value, and should be viewed as a good sign. With a stronger growth potential in 2011, we can look forward to more sustained job creation and further stabilization in property cash flow. A long road lies ahead, I’m not underestimating the challenge before us, but employment is trending in a positive direction.
Investment Activity
Following December’s year-end rush of closings, activity may appear to lull in the early months of the New Year. Offering volumes and deals now coming into contract portend a sustained improvement in activity underlying these seasonal fluctuations. As for how the market landscape will evolve over the next year, several key issues now dominate the drivers of investment trends:
More Balance Across Markets
Already evident from recent transaction activity, the erosion of yields in the most visible markets is now leading investors to broaden their sights. Buyer interest in relatively smaller-scale assets and in secondary and tertiary markets is on the upswing. Of course, the outlook for property fundamentals remains a consideration for many potential investors in these markets. As a result, improvements in pricing and sales volume have clearly favored high quality assets with strong tenant rolls and limited short-term exposure to leasing risk. Assets with this level of stability, and which are located in non-primary markets are now receiving considerable attention, which is another indication of an improving market. Investor willingness to geographically diversify will increase markedly in the coming quarters.
Less Distress But More Distress to Buy
Opportunities to invest in distress have been growing in 2010 though distress sales have not been allowed to overwhelm the market. Expect this to continue. For many investors, this controlled approach to distress management by banks and other lenders has been frustrating. The availability of distressed properties in the for-sale market will continue to increase in 2011, supported by generally improving investment conditions, and lender willingness to cleanse their balance sheets. But the floodgates will not be released and prices for these assets will remain higher than during previous cycles. Note sales will continue to play an integral part in the distressed asset market, and we expect loan sales volume to increase significantly in 2011.
Rising Interest Rates
One of the emerging challenges facing the industry results from rising interest rates. Up to now, the recovery has been supported by extraordinary interventions by the Federal Reserve, an absence of inflation, and very low interest rates. This combination of circumstances has kept borrowing costs low for qualifying investors and has also eased the path to refinancing and, in distress situations, modification of loans. In recent weeks, long-term interest rates have been rising even though inflation remains subdued. Already, higher treasury rates have resulted in a rise in 30-year residential mortgage rates, dampening the outlook for housing markets. In the arena of commercial real estate, we will have to remain watchful for the impact of rising interest rates on cap rates and the impact on borrowing costs. While cap rates will not necessarily rise with interest rates, lenders may be forced to raise lending rates.
Conclusions
• Buying into the recently firmed US market now, taking advantage of low interest rates (which have nowhere to go but up) is a strategy that many astute investors will implement. This said, we will not see a “rush” of activity stemming from the newly established pricing floor.
• Given the market’s positive momentum, locking-in historically low lease rates (for 5 & 10 yr. terms) will become much more prevalent in 2011. H2 leasing volume levels suggest that this is already occurring.
• Geographic diversity and a willingness to pursue quality investments in secondary & tertiary markets (where spreads are greater, competition is weaker) is a key to re-entering the market in 2011. We will see much more of this in the year ahead – first with performing assets in secondary markets, followed by same in tertiary markets.
• As opportunities to invest in distressed assets remain less than plentiful, real property investors will look to note acquisitions with more interest. In many respects, a note purchase will continue to be the shortest path to real property ownership of troubled assets.
• 2011 will represent a calendar year of overall recovery – more balanced than we saw in 2010, but not without fits and starts.
