Investment Sales in Small Cap Markets Accelerate in Third Quarter of 2016
November 16, 2016 | George Ratiu, Director, Quantitative and Commercial Research
Commercial sales transactions span the price spectrum, but tend to be measured and reported based on size. Commercial real estate (CRE) deals at the higher end—$2.5 million and above—comprise a large share of investment sales. Smaller commercial transactions tend to be obscured given their size. However, these smaller properties provide the types of commercial space where average Americans engage on a daily basis.
The National Association of REALTORS® Commercial Real Estate Outlook: 2016.Q4 report focuses on market performance in both large (LCRE) and small commercial (SCRE) sectors. The report provides an overview of economic indicators, investment sales and leasing fundamentals.
The U.S. economy picked up the pace in the third quarter of this year, boosted by positive consumer spending, as well as improved business investments and a jump in export activity. Employment continued growing during the third quarter, with a gain of 619,000 net new jobs. Over the January through September period, there were 1.6 million net new payroll positions, with 1.5 million in the private sector. Average weekly earnings of employees rose by 2.0 percent in the third quarter of this year, compared to one year earlier. The unemployment rate has been flat—at an average 4.9 percent—in the third quarter of 2016, at the same level for the first nine months of 2016.
The decline in large cap CRE sales volume which began at the beginning of 2016 continued into the third quarter of this year. The volume of commercial sales in LCRE markets totaled $114.8 billion, a two percent year-over-year decline, according to Real Capital Analytics (RCA). The decline curve moderated from the double-digit drop recorded in the first quarter. Given the preponderance of portfolio and entity-level transactions in 2015, their absence is casting a long shadow over this year’s activity.
The trend of diverging markets continued in the third quarter, with sales in the six major metros tracked by RCA posting an eight percent decline year-over-year. In comparison, sales in secondary markets declined only one percent, while volume in tertiary markets rose a noticeable 17 percent.
Commercial real estate in small cap markets found its path diverging at a higher rate, with sales volume accelerating during the third quarter of 2016. REALTORS® reported continued improvement in fundamentals and investment sales. Following on the first quarter’s 8.5 percent and second quarter’s 8.5 percent increases in sales volume, third quarter transactions advanced 11.0 percent on a yearly basis.
Underscoring investor approach to risk in the current markets, prices in LCRE markets rose. Based on preliminary data, prices in markets covered by RCA gained 8.9 percent during the third quarter of 2016. The advance was driven by strong appreciation in prices of apartment and industrial properties, which advanced 12.9 percent and 7.7 percent, respectively. Prices for retail properties increased 5.1 percent year-over-year, while office properties recorded a 4.4 percent rise.
Capitalization rate compression continued into the third quarter in LCRE markets. Based on RCA data, cap rates averaged 6.6 percent, 30 basis points lower compared with the prior year. The cap rate compression was registered across all property types, except hotels, but was more pronounced for apartment and office properties—down 60 and 40 basis points, respectively.
As investors across the value spectrum broadened their search for yield into secondary and tertiary markets, the shortage of available inventory remained the number one concern for commercial REALTORS®. Prices for CRE properties accelerated, posting a 7.7 percent yearly advance in the third quarter of this year. The pricing gap between sellers and buyers remained the second highest ranked concern. With banks continuing to tighten underwriting standards for commercial loans in the wake of increased regulatory scrutiny, financing availability was a concern in REALTORS®’ markets—14.0 percent of members ranked it as a main challenge in the third quarter.
Capitalization rates in SCRE markets continued compressing, to an average 7.2 percent across all property types, a 70 basis point compression on a yearly basis. Apartments posted the lowest cap rate, at 6.4 percent, followed by office properties with average cap rates at 6.8 percent. Retail and industrial transactions recorded cap rates of 7.1 percent and 7.6 percent, respectively. Hotel transactions posted the highest comparative cap rates—8.3 percent.
Commercial fundamentals are expected to continue on a positive trend, with three of the four core sectors favoring landlords. On the investment side, while financial markets’ volatility left a mark on the sales volume in large cap CRE markets during the first half of 2016, volume is expected to rebound slightly in the latter half of the year. In small cap CRE markets, increased scrutiny from banking regulators has tightened lending conditions, leading to more cautious capital flows into CRE transactions.
While the U.S. CRE markets have experienced diverging trends in 2016, the U.S. economy’s comparative strength coupled with low global yields translate into enduring appeal for commercial assets. While investors are approach risk from a defensive position, investment performance retains safety buffers even as the Federal Reserve is weighing acting on rates. Properties in secondary and tertiary markets remain well-positioned for growth.
To access the Commercial Real Estate Outlook: 2016.Q4 report visit http://www.realtor.org/reports/commercial-real-estate-outlook.