Four major trends affect commercial real estate

Robert Bray
Robert Bray

In the spirit of full disclosure, the subject matter for this column was covered in more detail in the National Real Estate Investor, an online publication to which I subscribe. Given the interest involved, here’s my take on the article.

First, let me spoil you with the conclusion: “The U.S. property market landscape in 2017 will be characterized by continued strong fundamentals, increased investor flows and high transaction volume.” Here are four reasons that validate the author’s thinking.

Global economics and political uncertainties make U.S. assets more attractive and valuable.  It’s no secret the U.S. commercial real estate market is seen as a safe haven for foreign investors wanting to park their money, and it’s been going on for several years now. Here’s a comparison that’s impressive. In 2015, foreign purchases of U.S. real estate assets rose to more than $87 billion versus just $5 billion in 2007. Wow, that’s a lot of money. The U.S. property market is the most transparent and stable in the world with higher yields and better appreciation. The other reason we’re seeing more investment from foreigners is recent changes to the 1980 Foreign Investment in Real Property Tax Act, which treats foreign investors the same as their U.S. counterparts.  So expect to see more foreign dollars flowing into U.S. commercial real estate for the foreseeable future.

Low interest rates and the cap rate environment are causing activity and movement in the commercial investment sector. Who’s not aware that interest rates for both home purchases and commercial lending have been at bargain basement prices for several years, many times bumping up against historic lows? If there’s a Federal Reserve rate increase in December, it’s expected to be minor and of little adverse effect. It just doesn’t pay to rob a bank these days with rates already so low. Continued cheap money will continue to spur additional real estate activity and the corresponding returns.

Cap rates, which I covered in a column a few months back, have experienced downward pressure in markets of high demand and competition for certain assets. These areas are referred to as “major” or “first-tier” markets versus secondary and tertiary markets. Examples of first-tier markets are major metropolitan areas and those along each coast. The consequence of intense competition for assets in these markets is reduced cap rates. Bidding up the price for an unchanged income stream forces the rate of return down. This phenomenon is now causing investors to seek assets in the next lower tier in looking for better returns. With that can come additional risk, but many are willing to take it. Denver constitutes a secondary market for most assets, but is seeing more activity because of heated prices in major markets. Grand Junction could be considered a tertiary or even fourth-tier market, but is seeing some movement because of too much competition in the upper markets. There’ll be more on Grand Junction in my forthcoming real estate forecast. The story on cap rates is that many investors are moving to lower-tier markets to sustain healthier returns and, along the way, accept more risk.

A slowing supply of new inventory can potentially cause upward price pressure and increased valuations. It’s the good old supply and demand lecture everybody heard in college economics classes. Although interest rates have remained low, traditional lending sources have been skeptical about funding new construction since the last recession. Moreover, lending activity is overly scrutinized by the Feds through hundreds — yes, hundreds — of new rules as a result of the Frank-Dodd act, including additional capital reserve requirements. Even with great rates, banks have a lot of money and still can’t get out into the marketplace. To an extent, insurance companies and private debt funds fill the gap. The conclusion here is that certain assets will see dramatic pricing pressure because demand exceeds supply. But the trend could be somewhat short-lived with new lenders coming back into the marketplace to fund new inventory.

A volatile energy market has had the effect of a double-edged sword depending on the area. In the recent past, the price of oil hit $110 a barrel, dropped significantly to a low of $27 a barrel early this year and has since climbed to about $45 a barrel. The sudden drop and sustained low price has had an adverse effect in such areas as North Dakota and Houston, not to mention producer nations like Saudi Arabia and Venezuela.  For most other metro areas in the United States, lower gasoline prices have had a net positive effect. Spending less on gasoline encourages consumers to spend the savings elsewhere. Likewise, lower energy related operating costs for a building can influence the net income for a property, translating to increased value. The author suggests the overall national economy is better off in the short term.  Given the fact the U.S. remains a net importer of oil to the tune of about $190 billion a year, any reduction in price curbs the trade balance.

In conclusion, there’s no conclusion as to where prices will go and when. So there you have it. I’ll offer more on the local real estate market with my annual forecast.