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10 Mar 2016 Expectations in Commercial Real Estate

Shortly after the housing market faltered, the commercial real estate (CRE) industry was also predicted to collapse. Despite price declines of as much as 40% across the commercial real estate sector, since 2011 the industry has experienced 4% annual growth as the value of private non-residential construction increased for the first time since the recession. In 2016, IBISWorld projects the industry to grow 1.8% and generate $922.9 billion in revenue, with revenue growth at 2.6% annually. Three fundamentals and macroeconomic trends to watch in 2016: interest rates, foreign capital inflows, and low energy/oil prices. Each is likely to contribute indirectly to the growth and recovery of the CRE industry.

In December 2015 the FOMC raised the target range of the FFR from 0-.25% to .25-.50% after nearly seven years being grounded at zero. In a statement the FOMC expects “gradual increases in the federal funds rate” as inflation stabilizes at 2% in the medium term and maximum employment is realized. In the months leading up to the anticipated rate hike, the 10-year Treasury bond yield increased from its 2015 low of 1.68 in February to closing at 2.27 on the year. Tracking the 10-year Treasury rates is crucial to CRE because changes in 10-year Treasury rates signal correlated changes in commercial and residential mortgage rates. Subsequently, these mortgages are packaged as mortgaged backed securities (MBS) and sold to similar investors as the 10-year Treasury bond; the main difference being the bond is guaranteed by the Fed. In the wake of increasing interest rates, investors will demand higher cap rates because the cost of debt is higher to leverage the purchase of an investment and investors would like to maintain a comfortable spread between cap rates and yields. The potential increase in rates by the Fed is a sign of confidence in an optimistic 2016. However, if rates do rise, top tier markets will be greatly affected. The pro-longed period of cheap capital has helped to keep property values afloat, but a long period of expensive debt is likely to have the opposite effect and cause a decrease in property value. As a result, borrowers will target cheaper properties while taking on higher risk. Such risk is likely to come in second and tertiary markets or niche type of property sectors. To avoid another bubble, it will be paramount lenders reduce LTV ratios by requiring more equity or collateral up front on loans. Lenders will also need to tighten lending standards and minimize risks, even on existing loans. Otherwise, rising interest rates are likely to lower property values and increase cap rates while at the same time lowering the amount of equity the borrower has in a given property. In this case due to the increased LTV ratio more debt may be needed to finance the decrease in equity of the loan.

On the flip side, if the Fed pursues a negative interest rate policy (as they have indicated could be a possibility), many of the expected outcomes in commercial real estate become even less concrete.

Other evidences of an improving US economy and one of the main drivers in its recovery are foreign acquisitions of United States commercial real estate.
Foreign investment has bolstered the recovery of CRE. Much of the interest began with the rescinding of the Foreign investment in Real Property Tax Act (FIRPTA) of 1980, which barred certain foreign capital inflows into U.S. commercial properties. . The rescinding of the act allowed the US to tax foreigners to have greater access to and investment in U.S. real properties. Consequently, hundreds of billions of new capital flowed into the United States. According to data by Real Capital Analytics (RCA), in 2015 CRE asset purchases rose to $78.4 billion, compared to about $28 billion in 2014 and $4.7 billion in 2009 ( the year foreign capital inflows to the U.S. increased dramatically). It is commonly known that investment capital from Asia-Pacific was a big source of cross-border capital. In fact, Canada, Norway, Singapore and China were respectively numbers one, two, three and four in total investment dollars flowing into U.S. commercial properties. Foreign capital is also now involved in investing in secondary and tertiary markets. Foreign investors see the U.S. as stable across the entire market, with transparency and large data available. Relative to China’s current devalued currency, slow growth and high unemployment in parts of Europe, political unrest in the Middle East and low oil prices, the U.S. seems to be leading the way in commercial real estate investing. With current unrest in Brazil, Venezuela, China, Spain, Greece, Iran, and Syria, it appears the U.S. is likely to remain a safe-haven for international capital inflows. Additionally, the reduction in oil and energy prices offers many opportunities oil-specific CRE properties.

Despite the low oil prices from a domestic perspective, macroeconomic factors seem to point toward overall steady growth in CRE. From a real estate perspective, the low oil and energy prices will only affect markets whose lessors are involved such as in Texas, Colorado, and other mid-west states. If oil prices remain low in these markets, there could be contractions in employment, which could decrease demand for industrial, office space, and residential properties. Thus far, there has been no drastic change in demand in Texas and the mid-west. In other parts of the country, low oil prices are beneficially impacting property demand. Better-than-expected holiday sales, slight increases in disposable income and overall demand for office space is helping to drive some commercial real estate growth. Slight increases in manufacturing and decreases in operational expenses across the board are also helping.

Commercial real estate in 2016 looks like another year of opportunity and possible surprises. What will be on a lot of investors minds is whether the Fed will continue to increase rates and by how much. An increase in rates is likely to cause higher costs in commercial and residential mortgage lending, leading to a decrease in property values in less-risky markets. Nevertheless, because rates have remained low for a long time foreign investment has increased drastically since 2009 and reached all-time highs in 2015. The money inflows into U.S.-based real estate assets is projected to continue as economic, political, and social turmoil occurs in other parts of the world. The oversupply of oil from OPEC, Russia, and others will hopefully ebb toward growth soon as well. Overall, low oil/energy prices provide future opportunity for retail, industrial, and residential property types as consumers have more money to spend and companies look to expand operations.

  • Anelalani

    Great analysis! It would be interesting to see an analysis like this for the residential real estate market. Also, another great discussion would be the effect of the high number of foreign investors in the United States real estate market and what the negative and positive effects that has on U.S. citizens and businesses.