Commercial Real Estate Debt: Values Have Likely Peaked
Sales volumes slowed again in the first half of 2017, and valuations have likely passed their cyclical peak.
Sales for the first half of the year are down 8 percent over the same period last year, and continue the trend of lower volumes since the peak in 2015. Apartment and retail sectors have seen the biggest declines at 17 percent and 16 percent, respectively. The only increase was in the industrial sector, which was up 10 percent. The slowdown in sales is a function of investors’ concern with slowing growth in net operating income, potentially higher interest rates, and the volume of new construction, especially for apartments. The slowing growth in net operating income is one of the top determinants of price as investors no longer view real estate as a double-digit growth vehicle. This has caused investors to be less aggressive on purchase prices and cap rates over the last year; combined with declining sales volume, this indicates to us that market valuations have peaked for this cycle. Meanwhile, sellers are under no significant pressure to sell as interest rates are still low, inflation is benign, and most properties other than retail are performing at high levels of actual net operating income. Neither side is willing to meet in the middle. With investors hesitant to buy, and sellers under no real pressure to sell, prices will likely remain flat to slightly down for the rest of the year for most properties. The industrial sector may be the outlier as the expanding economy has provided significant demand, led by new e-commerce participants.
Net Operating Income Dips Across All Sectors
The slowdown in U.S. real estate sales is a function of investors’ concern with slowing growth in net operating income, potentially higher interest rates, and the amount of new construction, especially for apartments.
Source: Real Capital Analytics, Guggenheim Investments. Data as of 7.27.2017.
Most Real Estate Prices Have Likely Peaked
With investors hesitant to buy, and sellers under no real pressure to sell, prices will likely remain flat to slightly down for the rest of the year for most property types. Industrial properties may be an exception due to demand from e-commerce tenants.
Source: Green Street, Guggenheim Investments. Data as of 7.25.2017.
With the slowdown in sales volume and the tail end of the ”wall of maturities” on lender balance sheets, we expect origination volumes to decline by 5–8 percent. Large deal activity is down 16 percent year to date compared to the same period last year, and single-asset transactions are down 6 percent. We do not think this trend will change in the second half. This slowdown will cause lenders to be aggressive, and they may lower spreads over the next few months to increase production.
With CMBS and Agency lenders quoting aggressively on 10-year terms, we like five- and seven-year paper, and longer terms up to 15 years where pricing is less competitive. The bridge and mezzanine space is still attractive, but spreads are being compressed due to the significant supply of capital to these higher-yielding transactions.
—William Bennett, Managing Director
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