Pricing Continues to Build Momentum at Lower End of CRE Market

April 03 , 2017

By Randyl Drummer

CCRSI Shows Mixed Results in February Amid Ongoing Slowing of Pricing Gains in High-Value

Lower-end commercial properties continued to log pricing gains for the second straight month in February, helping offset an ongoing pricing deceleration among larger assets in core U.S. markets, according to the latest released of CoStar Commercial Repeat-Sale Indices (CCRSI) data.
The value-weighted U.S. Composite Index, which reflects the sales of larger assets common in core markets, fell 1.4% in February following a similar decline of 1.2% in the month of January. However, the equal-weighted U.S. Composite Index, which reflects the more numerous but lower-priced property sales typically observed in secondary and tertiary markets, increased by 1.4% in February 2017, building upon a 1.9% gain the previous month.
The recent divergence likely reflects a maturing market cycle, particularly for the higher-value properties in core markets that led the recovery, even as both composite indices posted positive year-over-year growth.

The two sub-indices of the equal-weighted index mirrored the recent pricing trends. The CCRSI’s general commercial segment of the national composite index, which is influenced by smaller, lower-priced properties, increased 1.4% in February and 10.5% for the previous 12-month period, demonstrating the expansion of the pricing recovery across more U.S. markets. The investment-grade segment, meanwhile, which reflects the influence of higher-value properties on pricing, advanced by a slower 0.5% in February, and increased 2.8% during the 12 months ending in February 2017.

The continued overall demand for commercial space was reflected in the growth in net absorption across the office, retail, and industrial property types, which are projected to total 714.3 million square feet for the 12-month period ending in March 2017, a 6.8% increase from the same period ending a year ago.
The general commercial segment saw the strongest rate of absorption growth over the past year, with total net absorption projected to grow 19.1% in the 12-month period ending last month as the pricing recovery spread across the entire building size and quality spectrum. Net absorption in the investment-grade segment is expected to expand by 1.2% in the same period.

Composite pair volume grew a modest 1.9% to $132.2 billion in the 12-month period ending in February compared with the in the previous 12-month period that ended in February 2016. In January and February, however, year-to-date composite pair volume was lower than the same period in both 2015 and 2016, suggesting that the moderation in transaction activity that began last year from 2015’s record levels will continue into 2017.

U.S. Office Sector Enjoys Steady Q2 Leasing Momentum Even as Rent Growth Slows, Sales Stall

U.S. Office Sector Enjoys Steady Q2 Leasing Momentum Even
as Rent Growth Slows, Sales Stall

By Randy Drummer / CoStar

Availability of Prime Office Space Increasingly in Limited Supply as Majority of Markets See Vacancy
The U.S. office market continued its steady momentum in the second quarter, recording 39.4 million square feet of net
absorption in the first six months of 2016, nearly equaling the 40.2 million square feet absorbed during the record-setting
first half of last year.
The U.S. office vacancy rate ticked down another 15 basis points to 10.6% in the second quarter of 2016, well below the
long-term historical vacancy rate of 11.3%. CoStar analysts expect the office vacancy rate to continue trending lower
before bottoming out at around 10.2% in 2018, about the same as lowest point of the last real estate cycle.
“Basically, we expect to have two more years of occupancy recovery in the office market,” noted Walter Page, CoStar’s
director of office research, who presented the Mid-Year 2016 Office Review and Forecast along with Hans Nordby,
managing director for CoStar Portfolio Strategy and CoStar senior real estate economist Paul Leonard.
Several markets showed marked improvement at mid-year, including ones that were previously struggling, such as
Phoenix, which posted positive absorption of 3.4 million square feet.
In Seattle, which has enjoyed a particularly strong run, Amazon’s ongoing expansion helped drive 3.1 million square feet
in net absorption. Even Washington DC saw a welcome return of strength in the second quarter after several years of flat
demand growth. The D.C. office market absorbed a respectable 2.3 million square feet over the last four quarters.
“Finally, we’re starting to see some momentum in the D.C. marketplace, which should allow the vacancy numbers to start
inching downward,” said Page.
There were several notable exceptions. The energy sector slowdown and corporate relocations related to the completion
of several pending build-to-suit projects played a role in Houston and Dallas, which recorded absorption declines of 2.4
million and 3.7 million square feet, respectively, since mid-year 2015. San Francisco, Raleigh, Boston and San Diego also
logged declines due to a variety of factors.
But for the most part, the vast majority of office submarkets — 66% — saw their office vacancy decline in the second
quarter, and more than half of all U.S. office submarkets have a lower vacancy rate than during the previous market peak
in 2006-2007.
Demand for High Quality Space Resulting in Limited Supply
In a theme seen in many markets across the country, the supply of available space in newer, higher-quality office
buildings is becoming increasingly limited. With relatively little new development in the pipeline based on historical levels,
only about 81 million square feet of space is available today in buildings constructed over the last 10 years.
That total is less than half the 167 million square feet of vacant newer space that was available in 2007, according to
CoStar’s analysis.
Copyright (c) 2016 CoStar Realty Information, Inc. All rights reserved.
CONTINUED: U.S. Office Sector Enjoys Steady Q2 Leasing Momentum Even as Rent Growth Slows, Sales Stall
“While there are some exceptions where plenty of high quality, new office space remains available, such as Houston and
Washington, DC, for the most part we’re really tight on nice, new space,” noted Page.
Click to Expand. Story Continues Below
As evidence, Page noted that the vacancy rate for 4- and 5-Star office properties remained unchanged at 11.7%, despite
the fact that 90% of the new office space added to the market falls into that category.
Suburban office markets also continued to see increasing activity as large blocks of high-quality space become harder to
find — and more expensive — in most major markets, with the exception of Los Angeles, Seattle, Chicago and Atlanta,
where large blocks of downtown space remain readily available.
“Part of the story is that it’s now the suburbs’ turn in the cycle, and part of it is that the CBDs were so successful earlier in
the recovery cycle that there’s no place left to grow,” Nordby said.
As investors begin to focus on which markets are the most recession-resistant in the later innings of the recovery, certain
niches such as medical office space stand out, Nordby said.
Demand growth is nearly twice as strong for medical office as for regular office, and over the long term, medical office has
grown at about 1.3% annual rate compared to 0.7% for the broader office market, Page said. The medical office sector,
which has never had negative demand growth, even during the two recessionary periods since 2000, had a midyear
vacancy rate of 8% compared to the broader market’s 10.6%.
Click to Expand. Story Continues Below
Office construction stayed flat in the second quarter at about 130 million square feet under way, due in part of a large
decline in Houston. But building activity is still slightly above its long-term average of 125 million square feet, with
increased construction in D.C. and Atlanta, among other metros.
Some Cautionary Yellow Flags
While leasing and absorption levels remain robust and construction still well below historic levels, the U.S. office market
did see some cautionary flags in the second quarter, including a big slowdown in office sales activity and the beginning of
a slowdown in rent growth.
CoStar is projecting office rent growth will likely finish the year at an average of 3.4% and decelerate to the low 3% range
over the next year. As with all trends, there will likely be a few exceptions, including the Nashville, Atlanta and Florida
markets, where lower rents earlier in the cycle have limited construction. Also, rent growth in CBDs is expected to
continue to outpace suburban markets.
Meanwhile, reflecting declines across all the property types, the volume of office sales completed in the first half of 2016
declined compared to the same period one year earlier, according to preliminary CoStar data.
“It’s a worry,” Nordby said. “A decrease in transaction volume generally portends a decrease or at least a flattening in
And in another historical sign of softening demand, rising levels of surplus space placed on the sublease market by
tenants, is rising in a few markets. In Houston, the contraction of large energy tenants has caused sublet space to balloon
to more than 3.5% of total inventory. Companies such as Shell, ConocoPhillips, and BP have each put 500,000 square
feet on the sublet market in recent quarters.
Copyright (c) 2016 CoStar Realty Information, Inc. All rights reserved.

Investor, Tenant Demand for Shopping Centers…

Investor, Tenant Demand for Shopping Centers Holds Steady Despite Flattening Retail Sales Growth, Looming Store Closures
Lack of High-Quality Available Shopping Center Properties Hampers Both Retailers and Potential Buyers, Though Some Centers May Soon See Gaping Vacancy Holes
By Randyl Drummer
May 11, 2016

The U.S. retail real estate market recorded 11 million square feet of net absorption in the first quarter of 2016, causing the nation’s average vacancy rate to tick down to 6%, the lowest quarterly level since the Great Recession.

Despite a new wave of store closings and weaker-than-expected retail sales in the first quarter, solid U.S. job growth and wage gains suggest that retail demand should rebound over the remainder of 2016, said Suzanne Mulvee, CoStar Portfolio Strategy director of U.S. research, retail, during CoStar’s first-quarter State of the U.S. Retail Market Review and Forecast. Mulvee noted that a similarly weak first quarter occurred in 2015, followed by accelerated activity in the second half of the year.
However, the stable vacancy rate belies a challenging environment for some retailers as an increasing number of store chains look to ‘right-size’ their real estate holdings. The first quarter, typically the season for closures of underperforming stores, saw the largest level of closures since 2010, with retailers as diverse as Wal-Mart, Macy’s, American Eagle, Aeropostale and Kohl’s opting to close hundreds of brick-and-mortar locations, while a number of chains, including Sports Authority, filed for bankruptcy protection, according to Cushman & Wakefield data.

With the second quarter now well under way, the ominous rumbling of weak financial results and the specter of store shuttering continues, with retail analysts receiving several pieces of bad news this week. On Tuesday, a U.S. District Judge granted the Federal Trade Commission’s request to block the proposed $6.3 billion merger of Staples, Inc. and Office Depot. On Wednesday, Macy’s Inc. reported a worse-than-expected 7.4% sales decline in the first quarter, continuing a run of rough quarters for the department store chain.

Gap Inc. also reported weak sales and on Thursday, Kohl’s Corp. reported its first sales decline in six quarters, in a retail environment described by Kohl’s CEO Kevin Mansell and several other retail executives this week as challenging.

The Staples/Office Depot merger would have created a company with $37 billion in revenue and roughly 3,500 stores. Staples plans to host an investor conference call on May 16 to discuss “next steps in our go-forward strategy,” and the status of store closings is likely to be a major topic of interest among analysts. Recent earnings reports have suggested a difficult road ahead for both office supply chains, which are struggling to compete against such Internet retailers as Inc. against a business landscape increasingly oriented toward the digital and paperless office.

Staples closed more than 240 stores in 2014 and 2015 and expected to close another 50 stores this year, the company said in March after reporting lackluster fourth-quarter 2015 results. With the merger ended, Staples announced Tuesday it plans to cut $300 million in expenses and weigh the potential sale of its European operations. Office Depot closed nearly 350 stores over the same two-year period and has previously identified at least 400 stores for closing through 2016 as sales fell 10% in 2015.

Shopping center landlords faced with the losses of additional department stores anchor and junior anchor stores such Office Depot, Stables and Sports Authority are watching their tenants’ business situations very carefully.

“We’ve had intense conversations with both Staples and Office Depot. Whether there is a merger or not, once that’s decided, you will see store closings in that category,” noted Paul Freddo, senior executive vice president of leasing and development for shopping center owner DDR Corp.

The weak performance of Macy’s, meanwhile, prompted its executives on Wednesday to announce that the 700-store chain will consider proposals from potential joint venture partners for its mall stores. The company, which announced the closure of 40 stores in January, said Wednesday it has hired an executive to reevaluate its property portfolio to “monetize unproductive real estate.”
Retail Market Moving Past Recovery Stage

Despite the raft of store closings, retailer appetite for well-located space remains sharp. However, an increasing shortage of the most productive shopping center space, and limited new construction, is weighing on demand. As a result, retail vacancy may soon start to rise in New York City, San Francisco, Boston and other large metros.

Large retailers as a group have posted record profits and sales on a trailing four-quarter basis. However, net sales have plateaued over the last year and CoStar expects slowing sales growth to limit physical expansion for both high-end and discount chains. Median comparable-store sales growth was down to about 1% in early 2016, the lowest of the cycle, from a high of more than 3.5% in 2012.

“These numbers in aggregate indicate that public retailers will be pulling back on their expansion plans,” said Ryan McCullough, senior real estate economist for CoStar Portfolio Strategy. “The second implication of that is that the retail recovery has matured. We’re beyond the point where we’re talking about pent-up demand for retail and are now looking at underlying fundamentals driving retail sales growth.”
“There could be plenty of growth left, but calling it a recovery from this point forward may not be entirely accurate,” McCullough added.
Investors Eyeing Humble Neighborhood Shopping Center

Investment sales declined across all commercial property types in a seasonally weak first quarter following the record $500 billion sales volume in 2015. Retail property sales declined about 25.3% in the first three months, with sales of power centers slowing particularly rapidly, despite strong performance by home improvement anchors benefiting from the housing recovery such as Lowe’s and Home Depot.

Mulvee attributed the power center slowdown to lack of available product for sale rather than a pullback in tenant demand.

“We’ve seen so much buying by institutional investors who are now holding those properties, that there isn’t a lot of product available,” Mulvee said. “Some of the best fundamentals we’ve seen are in power centers, so the pullback doesn’t seem to be an indictment of that type of center.”

That being said, malls and power centers, particularly those located in strong commercial areas with strong household density and spending power, have hardly fallen out of favor among investors. For example, the largest transaction of the first quarter, Macerich Co.’s $770 million sale to Heitman of a 49% interest in a 3.3 million-square-foot portfolio of three malls in Colorado and New Jersey, includes properties in the upper echelon of U.S. retail clusters, with plenty of growth potential, McCullough noted.

Overall however, declining retail cap rates have started to flatten, in part due to the slowdown in power center sales, which have recorded the lowest cap rates of the cycle. Sales of strip and neighborhood centers, which tend to sell at higher cap rates, have become more active of late.
While cap rates of other retail subtypes seem to be reaching a bottom, “I would argue there is more runway for strip and neighborhood centers given the demand trends,” McCullough said.

“They’ve become more attractive to investors. The market hasn’t yet fully corrected for the demand shift, so there might be a relatively attractive yield,” McCullough added.

CRE lending surges in 4th quarter

From CostarGroup:

CRE Lending by Banks Surged in Fourth Quarter
Economic, Regulatory Headwinds May Slow Lending Pace in 2016
By Mark Heschmeyer
March 2, 2016

The total amount of commercial real estate loans held by U.S. banks and savings and loans saw a noticeable jump in the fourth quarter of 2015 over the previous quarter. The total amount of CRE loans outstanding held by FDIC-insured institutions increased 3.1% to $1.85 trillion at year-end from three months earlier. That followed an increase of 2.7% from mid-year to third quarter, according to the FDIC.

The $1.85 trillion year-end 2015 total CRE loans outstanding compares to $1.63 trillion at the last peak of the CRE markets at the end of June 2007.

Multifamily loans continued to increase at the fastest pace quarter to quarter, going up 4.6% to $15 billion from third quarter 2015 to the year-end total of $344 billion.

Non-residential commercial real estate lending totals jumped by $25 billion (3.6%) to $733 billion during the same timeframe.

Construction and development loan totals jumped by $8.88 billion (3.3%) to $275 billion.

The asset quality of CRE loans on bank books also continued to improve. Delinquent CRE loan balances declined for a 22nd consecutive quarter. At year-end, total delinquent CRE loans on the nation’s banks’ books equaled $19.8 billion, down 5.5% from the third quarter of 2015.

At the last peak of the CRE markets, delinquent CRE loans totaled $27.6 billion.

The total dollar volume of foreclosed upon CRE properties on banks’ books equaled $8.3 billion at year-end, down 12.2% from the previous quarter. However, in June 2007, the CRE foreclosed total stood at just $2.5 billion.

Banks appear to be benefitting from the strong market for real estate in selling any repossessed properties. For all of 2015, banks posted gains of $215.7 million on the sale of foreclosed properties. That came despite posting a loss on sales in the third quarter of 2015.

The nation’s largest CRE lender, Wells Fargo Bank, which holds about $134 billion in CRE loans, posted a gain of $245 million last year on the sale of foreclosed properties.

FDIC-insured institutions reported aggregate net income of $40.4 billion in the third quarter down from $43 billion in the second quarter of 2015.

Of the 6,270 insured institutions reporting third quarter financial results, more than half (58.9%) reported year-over-year growth in quarterly earnings. That also is down slightly from the previous quarter.

Is a Bank Lending Slowdown on the Horizon?

Total loans and leases at banks increased by $199 billion during the fourth quarter of 2015, approximately 2.3%. That is about double the pace of loan growth in the third quarter and the highest total increase in bank lending in eight years.

The brisk pace of bank lending may cool this year after bank regulators issued an announcement during the fourth quarter that they planned to pay close attention to real estate lending activity among banks.

The FDIC warned in late December directing banks and savings and loans to “reinforce prudent risk-management practices” for their commercial real estate lending.

The FDIC regulators added that they would be paying close attention to bank CRE lending practices in their 2016 bank reviews. The last time the FDIC sent such a memo regarding real estate lending was in 2005.

Asked in Federal Reserve Bank January 2016 survey about their lending practices, senior loan officers reported tightening standards for multifamily loans, a moderate number reported tightening standards for construction and land development loans (CLD loans), and a small number reported tightening standards for loans secured by nonfarm nonresidential properties.

“The operating environment for banks remains challenging. Interest rates have been exceptionally low for an extended period, and we are seeing signs of growing interest rate risk and credit risk,” said FDIC Chairman Martin J. Gruenberg. “Recently, domestic and international market developments have led to heightened concerns about the U.S. economic outlook and prospects for the banking industry. Thus far, the performance of banks has not been impacted materially. However, the full effect of lower energy and other commodity prices remains to be seen. Banks must remain vigilant as they manage interest rate risk, credit risk, and evolving market conditions. These challenges will continue to be a focus of ongoing supervisory attention,” Gruenberg said.

Fed Finally Raises Rates, Response from CRE Industry: ‘No Big Deal’

Fed Finally Raises Rates, Response from CRE Industry: ‘No Big Deal’
Interest Rate Hikes Reflect Expected Strengthening of Economic, Employment Conditions
By Mark Heschmeyer
CoStar Group

December 16, 2015
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After seven years of worrying over raising interest rates, discussing the best time to raise interest rates, and debating the impact of raising interest rates, money from the federal government is no longer free.

In a unanimous vote, the board of the Federal Reserve voted to raise interest rates a quarter of a percentage point.

The hike has been anticipated for nearly six months, thanks to a thorough communication strategy from the Fed that all but eliminated the element of surprise for a jittery stock market. The increase became a foregone conclusion following strong employment growth numbers last month.

Additional interest rate hikes are expected going forward, but will come slowly as the Fed continues to take an accommodative stance supporting further improvement in labor market conditions and a return to 2% inflation.

The impact from the decision could also take some time to surface.

“We do not believe today’s move will have any impact on the commercial real estate markets and that the Fed likely has significantly more room to move before we begin to see real pressure on cap rates,” said Spencer Levy, head of research, the Americas for CBRE. “That said, certain markets may be more susceptible than others to interest rate increases.”

The other wild cards Levy said could have a bigger impact than interest rates include the price of oil, an economic crash or ‘hard landing’ in China, which would lead to pull back in Chinese capital flows, or some other “black swan” event which would impair global growth.

Any such event could easily cause the Fed to reverse course, neutralizing any potential capital outflows, Levy said.

“The flow of international funds-combined with domestic pension funds’ large pools of capital allocated to commercial real estate but unspent-will outweigh any potential increase in the cost of capital,” he added.

Hans Nordby, managing director of CoStar Portfolio Strategy in Boston, agreed that today’s Fed rate hike should have little or no impact in the near term for private sector commercial real estate investors.

“First, while nominal cap rates are very low versus history, the spread between going-in cap rates and comparable investment vehicles, including bonds, stocks and treasuries, is very high,” said Nordby. “Therefore, rates can come up a bit before cap rates need to rise.

“Second, the Fed chose to increase rates because the ‘real’ economy, most notably job growth, is strong. Strong economies increase demand for real estate, and therefore rents. So, these increased rates are in tandem with higher incomes for the real estate, all else being equal,” he added.

“Finally, the fed is unlikely to push rates very hard in near future, given that growth outside the U.S. is very low, and the dollar is very high. Pushing up rates would make American exports even less competitive, just as foreign markets’ demand for U.S. goods is declining.”

Jeffrey Rinkov, CEO of Lee & Associates, said he also expects the rate hike will have minimal impact on commercial real estate.

“Based on a strengthening and stabilizing economy, I believe this was a logical move by the Fed,” Rinkov said. “While the Fed is driven by data, I think this signifies its belief that the economy can operate in an environment with a normalizing monitory policy. Relevant to real estate investment, long term interest rates should remain at historical low levels which will continue to incentivize investment.”

Housing Could See a Boost

One area that could see relief from a higher-rate environment is housing.

Steve A. Schwarzman, chairman and CEO of The Blackstone Group, took an informal show of hands survey last week at Goldman Sachs U.S. Financial Services Brokers Conference, asking the audience how many thought rising interest rates would hurt housing prices and then how many thought it would help.

Hardly anybody raised their hands when asked whether housing prices go down. And about a third of the room put up their hands very slowly when asked whether housing prices go up.

“Well,25 over the last 26 times in history when interest rates went up the value of houses went up,” Schwarzman said. “Because when you have inflation or you have people making more money with the economy growing, that tends to push up the value of houses.”

The more interesting question about interest rates, Schwarzman said is how slowly prices go up.

“But if the markets want to be down on real estate values, that’s okay,” Schwarzman said, “because then we’ll just take out some huge companies, put out huge amount of money at very good prices and what happens at the underlying assets are always worth way more than the stock market is willing to value at the stage and a cycle.”

Martha Peyton, managing director of TIAA-CREF Global Real Estate Strategy & Research, acknowledged that there are fears rooted in the perception that rising interest rates will weaken property values and commercial real estate (CRE) investment performance.

“But, historical data show that higher interest rates have not necessarily derailed CRE total returns, Peyton said. “In fact, property performance has often remained resilient in the face of rising rates. Furthermore, there are a number of factors that may provide protection to overall property performance in a rising interest rate environment.”

The most important protective factor, she said is that rate hikes in the current environment reflect expected strengthening of economic and employment conditions.