Author: Anthony J. Buonicore, Principal, The Buonicore Group
Sluggish economic growth and unusually harsh winter weather conditions during the first quarter did not derail recovery in the commercial real estate market. In fact, most of the underlying fundamentals (vacancy rate and rent growth) improved during the quarter. The multifamily market continues to do very well, with new construction climbing to meet strong demand. Office employment increased, which helped pull the office vacancy rate modestly lower and increase rents and sale prices slightly. Industrial activity also remained strong during the quarter, while retailing posted modest gains. The hospitality sector continues to do well, with strong international business now being supplemented by rebounding domestic travel.
Increased investment in the technology and energy sectors remains a major driving force behind the recovery. Markets with exposure to these industries are becoming more widespread and are experiencing some of the strongest employment and population gains.
Cap rates for the four major property types (multifamily, office, retail and industrial) trended lower (compression) in the first quarter giving rise to higher sale prices. Moody’s Investors Service reported that sale prices excluding distressed transactions now exceed their pre-crisis peak level. Even with distressed transactions included, sale prices are still only about 5% below their pre-crisis peak. In examining distressed sale prices in greater detail, CoStar reported that the distress percentage of total sales declined to approximately 10% in the first four months of the year, compared to almost 17% one year ago. It is now readily apparent that a significant volume of troubled assets have been cleaned up and resolved.
Continued strong growth in commercial real estate transaction volumes across all property sectors is expected for the remainder of the year as the market continues its recovery.
Individual Property Type Detail:
Multifamily sector fundamentals continue to outperform all major property types, but supply is expected to outpace demand this year. With demand moderating, the vacancy rate is expected to remain relatively flat throughout the year. Although demand has moderated somewhat from its peak in 2010, improving economic and job growth should keep absorption strong. Year-over-year effective rent growth has been relatively flat since the middle of last year, and is expected to remain moderate in the coming years as more supply comes on line. The expectation is that rent growth will be more pronounced in many secondary markets compared to the top primary markets as investors turn toward these secondary markets seeking higher yields.
Office sector fundamentals continue to improve, but progress has been modest. Office employment growth is increasing, driven by the improving national economy and the sparse level of new building activity. This has helped lower office vacancy rates and move rents higher, albeit only slightly. However, the vacancy rate is still above its pre-recession low and demand for space below its cycle peak. While major tech centers have been enjoying a building boom for the past two years, office fundamentals have improved enough in other markets to induce new construction there as well. Interestingly, a noticeable trend challenging office market growth is that the space allocated per worker continues to drop.
Industrial sector fundamentals continue to show improvement, with vacancy declining below its long-term average and rent growth increasing. Distribution hubs are expanding across the country as online and traditional retailers expand their networks to speed up delivery to the consumer. Demand for industrial space has been primarily driven by the explosive growth in online retailing which has driven big box warehouse and distribution center development around key distribution hubs. Changing global trade patterns and re-shoring of manufacturing operations back to the U.S. are other major trends driving the industrial sector. Several port cities along the East Coast are also seeing improvement, as port facilities expand to handle the increased trade volume expected after the Panama Canal is widened. Sales activity is expected to remain healthy for the remainder of the year and into next year.
The retail sector has been slow to gain any meaningful traction in this recovery and has generally lagged the other key property types. The shift away from the exclusive brick-and-mortar model has led many big-box stores to downsize floor plans and open fewer stores, a trend expected to persist for some time. Large anchor retailers also remain a concern as e-commerce takes a greater share of retail sales away from physical stores. On the positive side, however, the growing preference for urban living, particularly among younger households, has facilitated urban infill retail development.
The hospitality sector continues to perform well, with profits increasing, debt more readily available at attractive terms, and stable cap rates. Underlying property fundamentals remain strong, with positive year-over-year performance. This year marks the fifth consecutive year of RevPAR (revenue per available room) gains, placing the sector solidly in the middle of a long-term upward trajectory. Occupancy and profitability are expected to reach pre-recession levels this year. A key driving force behind the forward momentum is an abundance of equity capital, led by private equity and REITs. Total sale transaction volume for the year is expected to reach $25 billion. Sale transaction volume by REITs alone is expected to reach $5 billion. Investment by offshore sources is expected to reach almost $3 billion.
Commercial construction activity has been heavily driven by strength in energy and manufacturing-related projects. Warehouse and distribution construction is ramping up and construction of data centers remains strong. Two leading indicators of commercial real estate activity provide support for increased construction activity. The Dodge Momentum Index, published by McGraw Hill Construction and a measure of 20commercial and institutional construction activity, continued its upward track. It gained two percent in May, following a strong rebound in April after weather-induced declines in February and March. The Index is now 17.6% higher than a year ago. Requests for architectural design services, as measured by the Architecture Billings Index, published by the American Institute of Architects, also increased in May. The Index increased a sharp three percent to 52.6. Any score above 50 indicates increasing requests for building design services and that construction spending will likely increase nine to twelve months down the road.
The capital markets are now providing considerably more liquidity to the commercial property sector. The Mortgage Bankers Association is forecasting continuing increases in debt financing, with CMBS, bank and life insurance company financings expected to measurably increase. While long-term interest rates are still expected to tick up a few basis points, the increases are not expected to be disruptive to the commercial real estate market. The availability of multiple sources of capital bodes well for commercial real estate market recovery.
According to the Mortgage Bankers Association’s 1Q2014 Survey of Commercial/Multifamily Mortgage Bankers Originations, first quarter loan originations were 1% lower than during the same period last year and 45% lower than in the fourth quarter of 2013. The drop in the first quarter was strongly influenced by a decrease in originations for retail and multifamily properties. However, commercial and multifamily borrowing typically starts the year slowly, with less than 20% of the year’s total volume usually closed in the first quarter. Compared to last year’s first quarter, lending by banks and life insurance companies increased, but originations for Fannie Mae, Freddie Mac and for inclusion in CMBS were lower.
Commercial and multifamily debt outstanding increased by $11.1 billion in the first quarter, as three of the four major investor groups increased their holdings. Commercial banks led the charge, followed by life insurance companies and REITs. CMBS, CDO and other ABS issues saw a decrease. Mortgage debt backed by multifamily properties continued to grow at a faster pace than other property types.
The number of FDIC-insured institutions reporting financial results fell to 6,730 in the first quarter, down from 6,812 at the end of the fourth quarter of last year. In 2007, prior to the last fiscal crisis, there were 8,559 FDIC-insured banks reporting. During the first quarter of the year, five insured banks failed. In 2012, there were a total of 51 bank failures. Commercial real estate exposure continues to be the main driver behind problem loans at banks that failed in the quarter. The number of institutions on the FDIC’s problem list in 1Q14 continued to fall, declining from 467 to 411 during the quarter.
Real Capital Analytics (RCA) tracks the distressed commercial real estate asset market and recently reported $137.7 billion in distressed loans associated with 10,644 properties, down from $151.5 billion in distressed loans associated with 10,928 properties reported in the last quarter. The size of the distressed asset market peaked at $191.5 billion in October 2010. The $137.7 billion total consists of $93.2 billion in troubled loans associated with 6,893 properties (down from $103.5 billion associated with 7,113 properties in the last quarter) and $44.5 billion in lender REO associated with 3,751 properties (down from $47.9 billion in lender REO associated with 3,815 properties in the last quarter). Of the $394 billion of mortgages that became troubled since the 2007 market peak, more than three quarters have been resolved, and new instances of distress continue to decline.
The Federal Reserve’s April 2014 Senior Loan Officer Opinion Survey on Bank Lending Practices, found that 19 of the 72 banks surveyed indicated they experienced “moderately stronger” or “substantially stronger” demand for commercial (non-residential) real estate loans in the quarter. Fifty-two (52) of the 72 banks indicated the demand “stayed about the same as in the previous quarter.” Only one bank found the demand weaker. Twenty-one (21) of the 72 banks surveyed indicated that they experienced “moderately stronger” or “substantially stronger” demand for multifamily loans in the quarter. Forty-eight (48) of the 72 banks indicated the demand “stayed about the same as in the previous quarter.” Only three banks found the demand weaker.
The Mortgage Bankers Association in reviewing last year’s results for commercial/multifamily mortgage originators recently reported that:
– Wells Fargo led in total originator volume.
– JP Morgan Chase and Eastdil Secured led originators for CMBS.
– Bank of America, Merrill Lynch and PNC Real Estate led originators for commercial bank loans.
– MetLife Real Estate Investments and Prudential Mortgage Capital topped originators for life insurance companies.
– Wells Fargo and Walker & Dunlop led originators for Fannie Mae.
– CBRE Capital Markets and Berkadia led originators for Freddie Mac.
– Red Mortgage Capital and Greystone topped originators for FHA/Ginnie Mae.
– TIAA-CREF and Jones Lang LaSalle led originators for pension funds.
– CBRE Capital Markets and HFF led originators for credit companies.
– KeyBank and Eastdil Secured led originators for REITs, mortgage REITs and investment funds.
– Mesa West Capital and Meridian Capital Group led originators for specialty finance.
Commercial mortgage-backed securities issuance has been a cornerstone of commercial real estate financing. However, the competition to lend has made it more difficult for conduit lenders to make deals, which means fewer commercial mortgages for bond issuers to turn into CMBS issuances. In the first five months of the year, U.S. CMBS volume was down by about 25% compared to the same period in 2013. Issuance totaled $20.4 billion in 1Q14 and $6.2 billion in the 2Q14 through May 22nd. Most industry analysts still believe that total CMBS issuance this year will approach $100 billion. The current projection for next year is approximately $120 billion and $140 billion in 2016.
Delinquency rates for loans in CMBS continue their improvement trend. The U.S. CMBS 30+ days delinquency rate in May was 6.27%, down from 6.44% in April, 6.54% in March, and 9.07% in May 2013.
REITs and Life Insurance Companies
REITs have raised significantly less capital this year to date compared to what was raised in 2013 over the same period. U.S. equity REITs raised a total of $13.33 billion in capital as of April 4th, compared to $19.45 billion raised during the same period in 2013. The reason is believed to be related to the net asset value (NAV) of REITs. NAV premiums this year have been flat or even trading at a discount. It is reasonable to expect that REITs would rather raise equity when trading at a premium where they can get more cash for their shares. With REITs trading at a discount to NAV for much of the year so far, it is understandable how they may be swayed toward raising capital through “cheap debt” versus selling stock at a discount.
Commercial real estate lending by life insurance companies continues at a record pace. Lending is up 18% in 1Q14 compared to the same quarter last year. In a rising interest rate environment, life insurance companies have an advantage over many other lenders. Because they raise money from the premium payments of their customers, they are not forced to raise interest rates in lockstep with the rest of the market.
Property Transaction Market
Trends in commercial real estate transaction growth are traditionally reported on a sales dollar volume basis, rather than on a number of sales transactions basis. Unfortunately, if the interest is in gaining insight into the trend associated with the number of deals taking place in the market, reporting the trend on a sales dollar volume basis may be heavily biased by a few high-priced sales transactions. Insight into the trend in the number of commercial property sales transactions taking place may, however, be gained by reviewing property sales data collected and recorded in tax records at municipal offices. Fortunately, CoreLogic currently tracks these sales data for all major U.S. markets, although there may be a 60 to 90 day lag until the information is reported. Data reported by CoreLogic over the most recent five months is as follows:
November 2013 9,498 Commercial Real Estate Sales Transactions
December 2013 13,440
January 2014 9,320
February 2014 8,398
March 2014 8,982
[NOTE TO READERS: The data shown above includes only recorded sales transactions. They do not include leasing transactions (e.g., telecom deals where sites are leased, properties undergoing refinancing which may be a significant number and property loans being sold or securitized (CMBS).)]
APPENDIX: TRANSACTION ACTIVITY
The tables below show the most active buyers of “high quality” properties ($10 million or greater) in the past 12 months (in order of dollar volume acquired) as tracked by Real Capital Analytics. Italics indicate that this buyer has acquired additional properties beyond what was reported in last quarter’s Market Intelligence Report. Bold indicates a buyer newly added to the list in 2Q14. Regular font indicates no change from last quarter’s report.