Improving commercial property fundamentals, a steady stream of offshore capital and an accommodating Federal Reserve interest rate policy will sustain robust property investment in 2015 as buyers keep seeking yield and safe havens in the U.S.
But rising interest rates, the cooling of energy markets amid oil's price plummet, and other variables threaten to thwart those expectations. What's more, 2015 could be the year that reveals whether escalating property prices are sustainable, especially as underwriting becomes more aggressive.
Among other trends, buyers are building more ambitious rent-growth assumptions into their underwriting to make increasingly expensive deals pencil out, says Kenneth Riggs Jr., CEO of Houston-based Real Estate Research, a national commercial property valuation and consulting firm. That's a departure from the more recent conservative practice of pegging rent growth to inflation, he adds.
Up to this point, I think value and price have been in alignment," said Riggs, whose firm was acquired in February by global commercial real estate and loan advisory Situs. "But I think we're at an inflection point and may be getting ahead of our skis. Next year we may see price outpace value."
Momentum Continues
Through November, commercial property buyers and sellers had completed nearly $366 billion in U.S. deals in 2014, topping dollar volume for the full year of 2013 by almost $5 billion, according to Real Capital Analytics, which tracks sales of more than $2.5 million.
Capitalization rates have been trending down for most major property types over the last several quarters, indicating more aggressive pricing in anticipation of continued strong investment demand and low cost of capital. The rates measure a property's initial yield for the owners, and they fall as prices rise.
The average cap rate for office and industrial buildings in November marked a year-over-year decline of 50 basis points for each property type, to 6.6% and 7.1%, respectively, Real Capital says. Apartment properties fell 50 basis points to 5.8%.
Hessam Nadji, chief strategy officer for property brokerage Marcus & Millichap (NYSE:MMI), anticipates that vacancies in 2015 will keep tightening for most property types.
Retail properties could see the most pronounced improvement, Nadji says, with average vacancy rates dropping by 60 points next year to 6% nationally in light of growing small-business confidence. In November, the National Federation of Independent Business' small-business optimism index surged 2 points over October to 98.1, a slightly higher reading than the 40-year average. Apartments, however, may see vacancies rise nationally from a current average of around 4.5% amid increased supply, Nadji adds.
From an individual-markets viewpoint, the plunging price of sweet crude oil to less than $60 a barrel from around $100 six months ago could dent investment in cities tied to the energy sector, which along with technology markets have led the nation's commercial property recovery.
Much of the focus will be on Houston, where some 17.3 million square feet of office space was under construction in the third quarter, according to brokerage CBRE Group (NYSE:CBG). In a Houston report this month, CBRE noted that a "steep fall in oil prices" would have to last a couple quarters before energy companies would alter drilling and production projects, which are planned on a long-term horizon. But it said eliminated or scaled-back projects would ultimately reduce office demand in the market.
While Houston's average office rental rate climbed 4.4% to $26.81 per square foot in the third quarter from a year earlier, the average vacancy rate ticked up 20 basis points to 14.4% over the same period, Reis says. The fall in oil prices has caught the attention of Riggs, whose firm ranks the city as one of the top-performing property markets in the country.
"Houston's economy is more diversified than it used to be," he adds, "but falling oil prices will definitely slow the momentum."
Interest Rate Question
Rising interest rates could derail property investments on a broader scale. Yet observers who expected rate increases over the past few years now say that they wouldn't be surprised if interest rates begin and end 2015 without much change.
Still, investors are aware of higher-interest-rate risks, says Gerry Trainor, executive managing director of capital markets for Houston-based property brokerage Transwestern.
"But all in all, they're moving forward because it's anybody's guess as to what happens," said Trainor, who is based in the company's Washington, D.C., office. "I don't think anybody anticipates a big, sudden rise."
The yield on the 10-year Treasury note, a benchmark for conventional commercial real estate loans, would likely have to jump more than 80 basis points to around 3% or higher before investment activity would slow materially, adds Riggs. But the yield will stay lower longer than what most people expect, he argues.
"There's a tremendous weight on keeping Treasury yields down because of global uncertainty," he said.
Nadji notes that oil's recent price decline, combined with slowing economies in Asia and Europe, prompted overseas investors to buy U.S. Treasury notes in a flight to safety that pushed the 10-year yield down some 50 basis points over the last three months.
"In addition, any substantive rise in interest rates would be accompanied by strong economic and employment growth," he added, "both of which will boost demand of commercial real estate."
Similarly, a greater cost of capital won't deter foreign real estate investors who pay with cash, notes Avi Benamu, managing partner of New York-based real estate investment manager Winchester Equities. Like offshore Treasury buyers, individuals and families in the Middle East, Russia and other areas seeing strife are buying properties in the U.S. to protect their wealth, he says.
"Even if property prices seem a little bit unreasonable they'll just park their cash in the U.S. because they know it will be safe here," Benamu said. "The money is just flowing in."
Amid the trends, CBRE and Jones Lang LaSalle (NYSE:JLL) — the two largest companies by market cap in IBD's Real Estate-Development/Operations industry group — have risen by 33% and 48% in the stock market this year, respectively.
