Lack of New Development, Rising Demand Cited As Main Reason for ‘Cautious Optimism’
Despite signs of slowing recovery that prompted Federal Reserve officials Wednesday to issue a guarded assessment of the U.S. economy’s performance, most commercial real estate investors surveyed by PricewaterhouseCoopers LLP remain upbeat and optimistic that improving market conditions will lead to higher rents, property values and returns.
Weaker-than-expected job creation numbers and downward revisions in domestic growth in recent months suggest that the recovery in commercial property markets could be more protracted than expected. However, investors cited the lack of new supply, stronger corporate earnings, continued low interest rates and the sense that most fundamentals have stabilized or are improving as reasons for actively pursuing deals in nearly all property types, according to the second-quarter PwC Real Estate Investor Survey released Wednesday.
Survey participants represent a cross section of major institutional equity real estate investors, including REITs, pension funds, insurers, private equity, developers, CRE services firms and others.
“The significant lack of new supply over the past several years serves as the catalyst of the ongoing recovery,” said Mitch Roschelle, partner, U.S. real estate advisory practice leader for PwC. “As tenant demand continues to grow, positive absorption has begun to drive rents up. The prospects of rent growth have driven much of the aggressive bidding by investors in certain top-performing markets.”
“There are growing expectations of strong rent growth. Whether this occurs and especially whether it is sustainable will be a function of both the level of discipline exercised by developers and private sector hiring levels,” observed CoStar Group Senior Real Estate Strategist Chris Macke.
Rental rates remain below peak levels for institutional-grade assets in most property types and regions at present, although there’s a sense among respondents that they’ve stabilized. Average market rent changes reported by survey investors increased in 25 of the report’s 31 markets, further evidence of a slow but ongoing recovery.
Here’s a look at the sentiments expressed by investors in the PwC survey in the major CRE sectors.
The bullish sentiment expressed by investors has clearly moved beyond apartments into the office sphere, judging from the steep declines in office capitalization rates. Respondents said average overall office cap rates have fallen in 27 of the 31 surveyed markets during the second quarter, with the national cap rates for CBD and suburban office buildings falling 47 and 44 basis points, respectively.
The average overall cap rate for the national CBD office market declined for the fifth consecutive quarter moving below 7% for the first time since the second quarter of 2008. Among individual markets, Dallas saw the steepest decline at 51 basis points. One investor warned: “The worst thing to do now is overpay.”
Vacancy rate improvements are mainly occurring in the usual list of dominant downtown cores like San Francisco, Washington, D.C., and Midtown Manhattan. “Several cities in the Northeast are seeing positive events,” notes a participant, and even smaller cities like Baltimore and Philadelphia are reporting improvement. In fact, PwC’s Real Estate Barometer revealed that 10 of the 11 Northeast office markets will be in a recovery or expansion phase by year-end. Recovery will be slower in the Midwest and western markets, except for St. Louis and Minneapolis, which should see gain through 2014.
Investors are searching for both core and value-add deals as the CBD office market heals. “We are looking for Class-B assets in ‘A’ locations, where we see less cap rate compression occurring,” said one investor.
In the suburbs, “tenant demand is spotty at best and does not support rent growth for quite a while,” said a participant. The average going-in market rent change is “barely positive” and remains well below the peak of the cycle. Some surveyed investors expected to see rents decline as much as 5% in the year ahead.
While some tech and start-up companies prefer to occupy flex and research and development space, most flex demand comes from average suburban office tenants that view it as a cheaper alternative to traditional office space. And rental rates for traditional suburban office space have declined, causing demand for flex/R&D space to diminish — and along with it, investor interest.
According to the PwC Real Estate Barometer, 57.3% of the U.S. industrial real estate market will be in the recovery portion of the cycle by year-end. By the end of 2012, the percentage surges to 82.1%, and “the warehouse sector’s performance is really picking up steam,” claims an investor.
Despite the apparent rebound, most surveyed investors believe that developers planning new speculative warehouse projects should wait at least 12 to 24 months.
“This sector is still healing and needs to absorb more space before new buildings are added,” comments one participant.
Until then, there’s a growing desire by investors to own buildings, and improving fundamentals are slowly giving sellers more pricing power, despite relatively neutral market conditions.
Investor interest in the slowly recovering mall market is keen on stabilized, REIT-owned assets, which are showing steady or improving performance. But “quality malls are just not being put up for sale,” fretted an investor. On the other side, there’s a flood of lower-quality malls are being offered for sale by some of the top players, including Westfield Group, Simon Property Group, and General Growth Properties.
For power centers, survey participants reported that sale prices range from 60% to 110% of replacement cost, averaging 91.3%. A year ago, the average was 85%.
“Pricing has become more favorable for sellers of quality assets as signs of recovery have emerged,” notes an investor. Still, a bid-ask pricing gap exists in many instances as some buyers foresee continued angst in the retail sector. “This market continues to favor the buyer, but could shift to favor sellers quickly when consumer confidence gains momentum,” adds the investor.
While an investor said retail strip centers have become more stable” since last quarter, many markets still report weakness and high vacancies.
Investors continue to be hot for apartments, with roughly 64% of respondents viewing it as a seller’s market.
“Pricing is pretty frothy at this point, and some investors are willing to take a lower yield in year one simply to diversify their portfolio,” said a participant.
Surveyed investors anticipate an average 4.6% increase in apartment values over the next 12 months — a notable change from one year ago when participants expected an average value decline of 2.1%. Underwriting assumptions have grown optimistic, with average initial-year market rent change expectations increasing 261 basis points over the last five quarters.
At the same time, the market’s average overall cap rate has fallen due to investors’ preferences for well-leased apartment assets in strong locations.