Accurately forecasting the commercial real estate market’s performance is a nearly impossible task. There are far too many variables to assess and account for, but that doesn’t mean the effort isn’t a worthwhile endeavor. Taking a step back to examine how we got to where we are today and to consider what may lie ahead can be a useful and insightful exercise.
The current cycle of expansion’s duration, approximately 89 months and counting, has left market participants pondering when the music will finally stop (I’ll spare you the baseball analogy you are all no doubt tired of hearing). Given that expansion cycles have averaged 58 months since World War II, it’s a valid question, but not all cycles are alike. Other factors must be considered, and while duration alone cannot undermine an otherwise healthy market, this long period of expansion has given investors and lenders pause.
Judging by the current state of the market, it seems that, collectively, we have not forgotten the hard lessons learned during the last major economic downturn, often referred to as the Great Recession. Unlike typical market cycles, which often end in overbuilding that results in increasing vacancy, decreasing rents, and lower valuations, fundamentals are mostly good across the country. Factors contributing to healthy fundamentals include lenders scaling back construction lending, newly implemented federal regulations significantly increasing equity requirements, uncertainty relating to the election and investors taking time-outs to watch and observe how the market will absorb existing construction pipelines. While these factors may be “saving” the market from being overbuilt, they may also be stifling economic growth by preventing fundamentally sound projects from coming to fruition. As new construction inventory gets absorbed and lender balance sheets free up, hopefully more construction capital becomes available to fund good projects.
Additionally, a slowdown in permanent lending markets, particularly CMBS, has contributed to market uncertainty. New risk retention rules from Dodd-Frank are going into effect at a bad time in the market. Morningstar predicts that roughly 40% of the 2007 vintage 10-year CMBS loans coming due in 2017 are too highly leveraged to be refinanced, particularly suburban office and retail assets. Borrowers who are unable to refinance or de-lever may be forced to sell or give the keys back, possibly resulting in significant inventory hitting the market in 2017, thereby putting upward pressure on cap rates in those markets and creating opportunities for would-be buyers. Conversely, borrowers in markets and asset classes that have performed better since 2007, such as multi-family or assets located in supply-constrained urban markets, may be more likely to hold and refinance maturing debt, as replacing yield could prove challenging.
If the so-called Trump Rally and market optimism hold, interest rates will likely continue to increase in 2017. While cap rates have shown virtually no correlation with increases in interest rates during this cycle, cap rates will likely eventually succumb to upward interest rate pressure and rise accordingly, as many investors will no longer be able to obtain suitable leverage to finance investments. Keep in mind, however, that the benchmark 10-year US Treasury is still yielding about 60 bps below 2014 highs, so there’s still breathing room for the market to adjust accordingly.
As any real estate professional will tell you, opportunities are born as a result of disruption. There will be headwinds and challenges in any market and 2017 will be no different. Those who can capitalize on the opportunities created will reap the benefits. Metropolitan Capital Advisors (MCA) is looking forward to another exciting year of helping our clients capitalize on market opportunities. The author, Brandon Wilhite, is a senior director in the Dallas office of MCA. Brandon can be reached at (972) 267-0600 or by e-mail at firstname.lastname@example.org.