Commercial Real Estate Slows Down in Q2

By Auction.com, LLC, Special for USDR

Auction.com, LLC, the nation’s leading online real estate marketplace, today released its Q2 2015 Commercial Real Estate (CRE) Market Monitor™, which reveals that the CRE market is starting to show signs of stabilizing following a multi-year period of run-up and appreciation. After CRE deal volume bucked its typical cyclical trend by increasing in the first quarter from Q4 2014, volume declined 14.6 percent in the second quarter to $112.4 billion, but remains 24 percent higher than a year ago. The Q2 dip marked the first time since 2008 that total five-sector deal volume dropped on a quarter-over-quarter basis. Meanwhile, the hotel sector’s prices remain on the uptick, keeping it in the CRE spotlight with the strongest post-recession recovery of all sectors, outside of, perhaps, apartments.

“It’s unclear whether the Q2 drop in sales volume is the beginning of a slowdown in the CRE market, or simply an adjustment from an unusually strong first quarter,” said Auction.com Executive Vice President Rick Sharga. “What’s clear is that all of the major CRE sectors continue to perform far better than they did a year ago, and may be strong enough to withstand a potential decline in international investment activity due to the economic issues in China and  Europe.”

Europe has continued to struggle with high unemployment and low growth, leading the European Central Bank to start its own Quantitative Easing program to get lending and growth flowing again. This is especially important on the heels of the vote on Greece’s future in the Euro. This has depressed European interest rates compared to U.S. rates, which have risen throughout the year from 1.8 percent on the 10-year yield in January to 2.2 percent currently. The disparate monetary policies have the potential to shift capital flows away from the U.S. into Europe. This is only exacerbated by the surging U.S. dollar, which further dissuades international capital flows into the U.S. The combination of the rising dollar, interest rates and falling oil prices has greatly diminished the outlook for capital flows from Europe, South America, OPEC and Norway. The tenuous state of China’s economy also casts a shadow of uncertainty regarding CRE transaction trends.

“High liquidity in the commercial real estate market, reinforced by persistent price growth and tight cap rates, paints a picture of a strong, competitive market that has investors exploring secondary and tertiary markets and asset classes in the pursuit of high yields,” said Auction.com  Chief Economist Peter Muoio. “Of the five major sectors, the hotel sector is able to stand apart from the rest of the CRE markets’ recent dip thanks to a recovery in disposable household income, due to home price appreciation and cheaper energy costs that is leaving more money in consumers’ pockets.”

CRE Market Activity Overview

Stabilization appears to be underway, as evidenced by the Q2 decline in deal volume. Office sector deal volume declined 3.7 percent on the quarter but remained 24.1 percent higher than a year ago; industrial volume was down 18 percent on the quarter but up 39.8 percent year-over-year; retail volume dipped 28.1 percent from the first quarter but is up 21.9 percent from a year ago; apartment deal volume fell 11.4 percent on the quarter but grew 12.8 percent year-over-year; and hotel sector volume dropped 19.6 percent quarterly and grew 43.1 percent from a year ago.

CRE Deal Volume

Sources: RC Analytics, Auction.com Research

As to CRE valuations, the all-property price index is currently up 16.4 percent from a year ago, while office, apartment, industrial, and retail sector prices are up 20.1 percent, 15.4 percent, 14 percent, and 12.7 percent from a year ago, respectively. Hotel pricing, which is currently only available through the first quarter, skyrocketed 33.3 percent from a year ago. This is the highest current annual price growth pace of any sector. Hotel sector prices contracted on a year-over-year basis in the second and third quarter of 2014, but bounced back moderately in Q4 before exploding in the first.

Both hotel and retail sector pricing continue to work their way back toward pre-recession peaks, in contrast to the office, industrial, and apartment sectors, which have already surpassed these levels, according to the CPPI. Industrial prices hit a new peak in the first quarter before edging back in the second, but they remain 0.8 percent higher than their pre-recession top. This reflects the surge in the industrial sector’s recovery since early 2013, which is also substantiated by quickly improving fundamentals.

The hotel sector being a notable exception, the other four major real estate sectors have seen year-over-year price growth stabilize between 10 and 20 percent. The pace of annual growth in retail pricing had been slowing down from mid-2013 through mid-2014, but has recovered since then. Hotel price growth will likely cool down in the quarters to come but remain strong, since operating conditions, including room demand, average daily room rates, revenue per available room (RevPAR), and occupancy rates remain at or near all-time peaks.

264721

Year-Over-Year CRE Pricing

Sources: Moody’s, RC Analytics, Auction.com Research

Risk Premiums Declined from Q1

Auction.com’s calculations of CRE risk premiums show that they declined in the second quarter across all five CRE sectors. The 10-year U.S. Treasury rate, the other component of cap rates, jumped from 2 percent in Q1 to 2.4 percent in Q2, breaking a string of five straight quarterly declines.

“The Federal Reserve is expected to increase interest rates at some point in 2015, potentially as early as September, which would lead to increases in the 10-year U.S. Treasury rate, and potentially put upward pressure on cap rates,” said Auction.com Chief Economist Peter Muoio. “The risk premium serves as a buffer against the impact of rising interest rates on cap rates, but the Q2 decline in risk premiums chips away at this buffer, leaving cap rates more exposed to upward pressure on interest rates.”

The industrial risk premium saw the biggest quarterly decline, dropping 44 bps to 4.5 percent, 10 bps lower than a year ago. Apartment, retail, office, and hotel risk premiums trail slightly with respective 35, 33, 26, and 23 bps quarterly declines. Retail risk premium is also lower than a year ago, while office and hotel premiums remain higher than a year ago, and apartment figures are in line with their year ago level.

CRE Risk Premiums

Sources: RC Analytics, Department of the Treasury, Auction.com Research

Because of the Q2 increase in the 10-year U.S. Treasury rate, which jumped 40 bps on the quarter, cap rates generally leveled off or increased from the first quarter. All five sectors’ cap rates remain significantly below their 10-year average, but office and hotel cap rates jump 10 bps, while retail and apartment cap rates held steady. Only industrial cap rates compressed, tightening another 10 bps to 6.9 percent.

Muoio noted, “With the Federal Reserve likely to increase interest rates in the latter part of the year, we can expect the 10-year U.S. Treasury rate to jump further, potentially leading to further cap rate stabilization if risk premiums compress, or higher cap rates if risk premiums hold pat or also increase.”

CRE Cap Rates

CRE Sector

Current Cap Rate

10-Year Average

High

Low

Office

6.8%

7.2%

9.3%

6.5%

Apartment

6.0%

6.4%

8.7%

6.0%

Retail

6.6%

7.1%

9.1%

6.5%

Industrial

6.9%

7.5%

9.5%

6.8%

Hotel

8.2%

8.5%

9.9%

7.8%

Sources: RC Analytics, Auction.com Research

About Auction.com:

Auction.com, LLC, is the nation’s leading online real estate marketplace. Founded in 2007, the company has sold over $30 billion in residential and commercial real estate assets. Auction.com has over 900 employees and headquarters in Irvine and Silicon Valley, Calif., as well as offices in Austin and Plano, Texas, Atlanta, Denver, New York and Miami. Visit www.auction.com for more information.

SOURCE Auction.com, LLC

All opinions expressed on USDR are those of the author and not necessarily those of US Daily Review.
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