What Inning Are We In? Let’s Play Two!
By Jim Costello, Real Capital Analytics
Over the years, some of the most insightful comments expressed at NAREIM meetings have come from Jim Costello. A real estate and urban economist with Real Capital Analytics, Jim provided advice to the Treasury Department and other policy makers in the aftermath of the Global Financial Crisis and helped educate these professionals on commercial real estate performance. Jim has recently been made a member of the Commercial Board of Governors of the Mortgage Bankers Administration and is working there as well to help policy makers understand our industry.
Commercial property investors are at a confusing spot. After growing at a double digit pace in the last few years, both property prices and volume have now fallen. When positive trends were steady, experts and professionals at industry conferences were asking the same question, “What inning are we in?” We are now in game two of a double header.
There was an embedded set of assumptions in the way that question was asked. The main assumption was that the good times would not last forever. Additionally, there was an unspoken concern at industry conferences was that the end would come with pain, tears, sharply falling asset values and many participants looking for new work. It need not end that way.
In January, the Moody’s RCA CPPI TM recorded the first monthly decline in six years — falling 0.3% for the all-property composite and down 0.8% for core commercial properties (i.e, offices, retail, industrial). Is this monthly decline a sign that the last batter has struck out, the 9th inning is over and some will need to look for new work? Not exactly.
The assumption that the previous market cycle must end in tears is flawed. Yes, the declines in the Moody’s RCA CPPI TM into the Global Financial Crisis (GFC) were brutal and sharp, but every market cycle is not the same, just as every cycle is not the same in terms of drivers and outcomes. January’s figures do not suggest that we are on a precipice due for a sharp fall in prices like that seen in the GFC.
Prices grew to then-record highs in 2007 on the back of excessive investor optimism on future growth prospects. At the end, buyers were paying for assets with cap rates lower than the rate of interest on their mortgages. Such deals would only make sense if property income grew well outside of historic norms. Unfortunately for those buyers, their assumptions on underwriting did not pan out and debt market liquidity disappeared at the wrong time.
Price growth in this cycle was a function of two forces. First debt market liquidity returned early in the first game of the double header led by insurance companies, then banks, and closing it out, CMBS lenders in later innings. With debt back at moderate LTVs, deals got done and both pricing and transaction volume picked up steam. The lack of debt market liquidity suppressed prices and deal activity, which came roaring back as debt normalized.
In later innings though, prices continued to grow as the metrics relative to other asset classes were just too hard to resist. As a result of Quantitative Easing and other Central Bank intervention, rates of return were pushed down at all points on the yield curve. The rich spreads offered by commercial real estate cap rates to bond instruments were simply too attractive — bringing more capital into the sector and continuing the upward pressure on pricing and volume.
So what drove the 0.3% decline in January and where is it going to end? Is commercial real estate no longer attractive, are investors looking for opportunities elsewhere? Is the game over with only the ground crew left to service a mess?
The Moody’s RCA CPPI TM acts a bit as a spot market price, but even still, trailing activity has an influence on current values. The fact that cap rates had flattened out nationally in recent months was a clear indicator that some change to the pattern of price growth would be coming. If cap rates are flat, unless property income is growing at double digit rates, price growth cannot continue at double-digit rates.
Compounding this flattening of cap rates, liquidity in the commercial real estate debt markets experienced a shock late in 2015. CMBS spreads went up 40 bps in September in response to corporate bond market uncertainty. The pace of deal volume slowed as buyers and sellers came to grips with that movement. With some CMBS debt costs higher some buyers may not have been as willing to stretch on prices.
None of these recent changes in the commercial property markets leave us in a place where prices will fall at double-digit rates as in the aftermath of the GFC. Debt liquidity experienced a shock, but it is not going away. Life Insurance companies are active as are banks despite challenges from new CCAR and HVCRE regulations. Furthermore, with ongoing low interest rates, the CMBS debt costs have eased somewhat into March of 2016.
As a sign of the importance of this debt market shock, prices for apartment properties were up 0.8% in January. This sector of course is heavily dependent on the GSEs for financing and they have stayed in the game even as other lenders pulled back. Once the story on the sources and quantity of debt for 2016 becomes clearer, buyers and sellers will be able to agree on prices more easily and, while not growing at double digit rates, transaction activity can continue.
Additionally, commercial real estate is still offering an attractive spread between cap rates and bond market instruments. Yes, the Federal Reserve Bank raised the Discount rate a smidge, but all other points on the yield curve are now lower with investor jitters keeping the all-important 10yr UST back below 2% as of late March 2016. There is not much pressure to see further cap rate compression given an expectation that at some point we will see a 10yr UST back in the 3% range. With the spreads in place today, current cap rates will still offer investors an attractive yield relative to other fixed income asset classes.
We are left in a new game in a double header. Our best offense won it for us in the first game, but it will not be back for the second. The next game will be more challenging — there will be innings where the market is down, yet other innings with thrilling gains. Some investors who only focused on the cap rate compression-driven gains of the last game may sit out this second match, but many others will still find reason to be in it.
In the words of Ernie Banks, “It’s a beautiful day for a ballgame, let’s play two!”← Georgetown Wins 1st place in the 2016 MIT Case Competition A&D 2016 Meeting Report: Adaptation is the Seed of Evolution →