Commercial Real Estate
A “State of the Market”
For the last few years we have enjoyed the perfect ride in commercial real estate, with the simultaneous occurrence of stabilizing rents, improving fundamentals, and really, really cheap money. Banks, insurance companies and institutional investors funneled money into the market because its returns, in an environment of low interest rates, exceeded those of alternative asset classes. This segment of the broader real estate market typically includes office, retail, multifamily, and industrial properties.
Although investments in commercial real estate continue to be strong, in the multi-family sector, “real estate fundamentals are on the mend,” according to Caroline Blakely, a vice president in multifamily housing and community development at Fannie Mae. U.S. demographic trends and steady job growth bode well for apartment rentals. In line with that, vacancies are declining and asking rents are climbing. Fannie Mae is slightly less optimistic about rent growth than other institutions in the real estate industry.
After the 2000 dot-com crash, commercial real estate revenues declined, vacancies rose, and rents decreased. But since late 2001, revenues have steadily increased, with investors pouring more money into the sector. The key was the Federal Reserve flooding the market with liquidity through low interest rates, enabling commercial real estate investors to enjoy phenomenal returns in the face of poor fundamentals. One result was extremely low levels of delinquencies and default for banks’ commercial real estate portfolios.
Analysts remain bullish on commercial real estate returns because fundamentals have improved in recent years; however, they expect to see a “significant slowdown” in price appreciation for real estate. High prices still being paid in some areas of the apartment sector are “worrisome.” However, property transactions overall have already slowed this year and buyers have been holding out for better prices. In this view, this “cooling” is rational and a sign that some of the effects of higher interest rates are percolating through the system.
A positive commercial real estate market is predicated on its positive economic views. All bets are off in a “stagflationary” scenario or if job growth tanks, or if we get real significant increases in interest rates. (Brian Lancaster, Wachovia Securities)
Some real estate professionals are less sanguine about prospects for the commercial real estate market, agreeing that commercial real estate is currently in a good position, and that the U.S. economy’s strength and resilience will benefit the industry generally. However, the world we live in now is more global than it was 10 or 20 years ago and capital can be rapidly pulled out of markets because of events that occur thousands of miles away. That makes commercial real estate’s status as a “favored child” more precarious.
Capital market integration and securitization is going on and is inevitable. Securitization refers to the pooling together of relatively illiquid assets into more diversified financial products, whose securities are then sold to investors. This enables markets to develop by expanding their investor base and providing lower-cost financing. However, investors can now respond to new information more quickly than ever before – and this has the potential to create more volatility, not less.
What could happen to us? China could revalue its currency faster than expected, translating into higher prices in the U.S., which would impact the real estate market. An unanticipated jump in U.S. interest rates could also cause investors to shed real estate very quickly. All you need is a few performance failures, because a lot of real estate is being bought with the notion that there will be growth in fundamentals. We could possibly be at a very high risk point in commercial real estate. (Richard Edelstein, a professor at the Haas School of Business at the University of California at Berkeley).
Sources: Caroline Blakely, a vice president in multifamily housing and community development at Fannie Mae; Richard Edelstein, a professor at the Haas School of Business at the University of California at Berkeley; and Bradford Case, an economist with the Board of Governors of the Federal Reserve System.
— Margaret (Missy) Davis-Whiddon
Vanguard Commercial Realty
