As we look forward to 2014, Sperry Van Ness is pleased to share its perspective on the very memorable year now behind us and to offer its outlook for the commercial real estate investment market. In the text that follows, Sperry Van Ness is sharing not only its insight, but more importantly the data, interpretations and forecasts of exemplary SVN Advisors and Product Council Leaders.
THE CHANGING CONTEXT OF THE REAL ESTATE RECOVERY
Data at SVN and beyond shows that 2013 was a banner year for the commercial real estate industry, with investors working to move past the recovery paradigm and driving property trades to their highest levels since 2007. Easily surpassing $300 billion in mortgage-financed sales, the industry over the last year has rebounded more than threefold from its 2009 trough. The gains in 2013 were more balanced than in previous years and improvements in industrial, office, retail, and non-core property sales were on par with the more mature upswing in apartments. Land sales picked up as new opportunities for profitable development emerged. An even more important milestone, investment momentum broadened over the year from its relatively narrow focus on a small number of prime markets to include a much wider range of assets, locations, and investors.
Apart from a further shift in momentum to secondary markets and small- and mid-cap assets, cyclical forces shape the outlook for real estate in 2014. A growing economy, improving property fundamentals, modest construction, and easier access to financing collectively offset drags that will follow from tighter monetary policy, rising interest rates, and uncertainties relating to the job market.
In the apartment sector, the status quo of very weak housing outcomes and limited new supply is shifting. As some households revisit the opportunity for homeownership, apartment demand is adjusting to a still-robust but more sustainable level. Construction projects are reaching completion in larger numbers, affording a healthier balance of supply and demand even as some developers overshoot the mark.
Secular trends will also define the next year. Housing finance reform, if it gains traction during the current Congress, could radically and permanently alter the cost and availability of debt for all classes of housing, including multifamily. Across property types, new technologies continue to foment tremendous changes in the way we find and use space, as tenants and investors. Technology is also challenging the norms of how we facilitate the real estate investment market; new models will favor a more open and efficient ecosystem and the market participants who embrace it.
SHIFT TO SECONDARY MARKETS
At the top of the metro rankings, the most liquid prime markets—including Boston, Los Angeles, New York, San Francisco, and Washington, DC—saw continued capital inflows from large institutional investors. The increasingly common frenzy of bidders on trophy assets was not limited to public REITs, large real estate operating companies, and domestic pension funds. Even as global economic conditions stabilized, foreign investors and lenders flocked to the United States, not just as a safe haven but also as their best opportunity for long-term capital appreciation. According to the membership of the Association of Foreign Investors in Real Estate (AFIRE), New York outranked all other markets globally in its investment potential last year, followed closely by the Beltway. Although Washington has lost much of its luster in the most recent rankings and London has reclaimed the top spot from New York, four of five global markets are in the United States.
The relative saturation of leading markets with equity and debt capital has seen core property yields hold at their rock bottoms, even as interest rates have trended higher. Values held during the second quarter’s Treasury yield shocks. With trophy and large-cap prices now surpassing their pre-crisis peaks, the upside in these market segments is more limited than just a few years ago. In the hunt for yield, SVN data show that some buyers are constrained by investment criteria that limit their moves out of global cities. Others are not, and are now joining private investors in seizing opportunities for returns in the mid- and small-cap segments.
This plodding recovery in secondary markets contrasts sharply with conditions in the most visible metros. Even among secondary markets that have recorded breakaway growth in the energy, tech and new media sectors, investors and lenders had been wary of re-engaging too early. That wariness diminished considerably in 2013, aided by reinvigorated CMBS conduit lenders. Among the pivotal developments of the last year, the long-anticipated secondary market rebound is now well underway. With each succeeding quarter, secondary markets now account for a larger share of overall sales volume both at SVN and within the industry as a whole. That trend will carry forward into 2014. As much as “bifurcation” so aptly described the early stages of the commercial real estate recovery, the next year will belong to small- and mid-cap properties and investors.
A NEW TRAJECTORY FOR THE ECONOMY AND INDUSTRY
The overriding trends at work in the commercial real estate sector show we have good reason to be optimistic. They also hint at an industry that is changing, where collaboration and open platforms are replacing the old models of fragmentation and information asymmetry. Market participants that aggressively guard proprietary information as their store of value are becoming less relevant. The impact of new technologies on real estate is usually discussed in terms of demand for different types of space. But the business of commercial real estate is itself changing. Like other industries, that implies great opportunity for innovators and a more challenging path for the less adaptable.
It is rarely clear which of the new approaches to market making will be disruptive and which will fall by the wayside. But experimentation is part of the process of entrepreneurship that inevitably leads forward. New ways of doing things, navigating secondary markets’ higher risk-return profiles, and an industry pulling away from recovery mean that our Advisors serve in increasingly important roles as facilitators of the market. The success of SVN Advisors in working to bring online auctions into the main stream over the last year as well as our open Monday sales calls, point to a year of progress against a backdrop of stronger economics and capital markets:
Supporting real estate’s broader investment momentum, buyers and lenders became more confident during 2013 in their expectations for the economy. Their positive assessments were bolstered during the third quarter. In spite of headwinds from the government shutdown and debt ceiling debate, the economy expanded close to its fastest pace since the recovery got underway. The consensus projection puts GDP growth near 3 percent in 2014 and 2015, closer to its potential. At the same time, inflation is expected to remain subdued.
While the economy is poised for stronger growth, the labor market is also a critical gauge of demand period that economic growth and corporate profits do not necessarily coincide with stronger hiring. Although we have replaced most of the jobs lost during the recession, the share of Americans who are not working remains unacceptably high. The potential for disappointing job and wage gains was reinforced in the December employment report, which showed the smallest net increase in employment in nearly three years.
Pending fresh momentum in the job market, diminished downside risks to growth are prompting a less supportive stance from monetary policy. Historically low interest rates have been one of the primary supports for the economy and property markets. Lower yields on the safe harbor investment of US Treasuries have allowed lower borrowing costs, debt yields, and cap rates. Hints at tightening by the Federal Reserve pushed Treasury prices lower during the second and third quarters, with little impact on property values.
Chandan Economics reports that interest rates on long-term commercial mortgages increased marginally over the same period and during the third and fourth quarters. Financing is no longer
at a historic low, but the availability of secured mortgages has improved dramatically in secondary markets. In the period following the financial crisis, traditional sources of commercial real estate lending were largely disengaged. Bank lenders had refocused on managing legacy distress and, under pressure from regulators, hesitated to make loans to all but the most established borrowers. CMBS conduit lenders were absent from the market altogether. More active regional and community banks, credit unions, and CMBS lenders is a critical piece of the market puzzle that is falling
The prospects for commercial real estate are bright. Downside risks remain a feature of the market, but are overshadowed by strengthening tailwinds. In a shift from the early recovery, that can be said for investors across a wide range of markets. Engaging on this larger investment landscape means that information and insight is more important than ever. In this environment, the Advisor serves an even more important role in making markets work. I am confident that it is an environment that we are well prepared for and in which we will thrive over the coming year.