Ten-X Commercial, the nation’s leading online and only end-to-end transaction platform for commercial real estate, has released its latest Commercial Real Estate Volume & Pricing Trends report, which shows that transaction volume across the five commercial real estate sectors totaled $107 billion in Q1 2018. According to Real Capital Analytics, first-quarter investment activity rose by 6.7 percent compared to Q1 2017 as the industry started the year stronger than in 2017. While total deal volume is lower than the third or fourth quarters of 2017, it is not unexpected as transaction volume is historically lower in the first quarter of the year since investors seek to close deals before the end of the calendar year.
Buyers and sellers are still grappling with a gap in pricing expectations, especially as interest rates have risen and the U.S. Treasury 10-Year bond yield approaches 3 percent. Heavy supply is looming in the apartment, hotel and industrial sectors, while technological innovation is crimping demand for both office and retail space. As such, buyers are wary of high price points and tight cap rates, while sellers are demanding the aggressive valuations that were common in years past.
“While some have anticipated the bottom falling out of the market for more than a year, Q1’s year-over-year uptick in deal volume suggests resilience in the commercial real estate sector,” said Ten-X Chief Economist Peter Muoio. “Even as some owners continue to demand the high valuations of yesteryear, a fair amount of market participants have recognized the new realities and found enough common ground to get deals done.”
CRE Transaction Volume Remains Subdued
Transaction volume in the apartment and office sectors saw the most substantial quarterly declines, dropping by about $12 billion and $9.5 billion, respectively. These losses were too large to be offset by modest gains in the hotel and industrial sectors of $4.5 billion and $2.2 billion. A $2.4 billion loss in the retail sector further weighed on overall transaction volume.
Industrial’s portion of total deal activity approached its peak in the first quarter of 2018 at 19.5 percent, as its transaction volume was nearly double its 10-year average. The apartment sector maintained its traditionally large share of total deal volume, at 32.5 percent, but suffered a 500-bps decline, the largest quarterly drop of the five sectors.
The office sector’s share of total deal volume fell 400 bps to 25.6 percent. Retail gained 600 bps of volume share, rising to 12.3 percent, while hotel deal volume jumped by more than 60 percent, boosting its share of total volume to 10.2 percent. Several large transactions and portfolio deals closed in Q1, boosting hotel volume.
Property Pricing Continues to Underwhelm in New Year
Property valuations fell 1.4 percent year-over-year in April, per the Ten-X All Property Nowcast which gauges national pricing through a combination of proprietary and third-party data. It is now below its year-ago level for the first time in the history of the index, as consistent gains in interest rates and volatility in equity prices are beginning to weigh on CRE pricing. Month-over-month, the CRE Nowcast eked out a 0.1 percent gain.
The five major property segments saw mixed results in April, with only office and retail managing gains.
The Ten-X Office Nowcast increased by 0.6 percent in April — the biggest monthly gain of any property sector. With the Office Nowcast now having climbed in three of the past four months, it is up 1 percent on the year, but this overall increase masks bifurcations in regional pricing.
Despite persistently poor fundamentals and record-level retailer bankruptcies due to increases in e-commerce, the Ten-X Retail Nowcast remained solid. The Retail Nowcast rose 0.5 percent in April, resulting in a 3.4 percent year-over-year gain, though this marks its slowest pace in over three years.
Industrial pricing weakened on a monthly basis for the fifth time in six months in April, this time by 0.7 percent. This loss generated a contraction of 5.1 percent year-over-year, the worst annual performance among the covered segments. Much like the Retail Nowcast, these movements were somewhat surprising in light of positive headlines and robust fundamentals that characterize the industrial sector. The weak industrial pricing may be attributed to investor concern about shifts in trade policy.
On a monthly basis, the apartment and hotel Nowcasts saw very little change, though both declined a respective 2.3 percent and 3.9 percent on the year. Weakening in the Ten-X Apartment Nowcast may reflect investor unease about fundamentals as new supply has increased.
The 0.1 percent monthly decline in hotel pricing was the sector’s third monthly decline in the last four months, as hotel pricing fell fairly evenly across most regions of the US. Hotel fundamentals got a temporary boost at the end of the year from dislocations due to natural disasters in Houston and Florida. Overall, demand remained healthy in the first quarter, but heavy supply additions continue to pressure occupancies in many large markets.
Risk Premiums Fall Slightly as Treasury Rates See Minor Rise
The Federal Reserve raised interest rates in March for the sixth time since December 2015, when they were at near-zero levels. If the economy continues to perform well, it is likely there will be a tightening in monetary policy, especially as wage growth increases and there are signs of incipient inflationary pressure.
Yields on 10-year U.S. Treasuries rose to 2.8 percent in the first quarter hitting 3 percent in May, their highest level since the beginning of 2014. They also rose 40-bps quarter-over-quarter. Retail cap rates saw the biggest change, climbing 30 bps to 6.4 percent, while other sectors saw more modest changes.
Industrial risk premiums – the spread between the cap rate and the 10-year Treasury – fell 50 bps over the year to just 2.9 percent, registering below 3 percent for the first time since the recession. Apartment spreads are down 40 bps from a year ago to their lowest level in four years at 2.3 percent and remain the narrowest of all the sectors. Risk premiums in both the office and retail sector sectors are unchanged from their year-ago levels, at a respective 3.4 percent and 3.6 percent, though these marks are still historically low. All segments now show risk premiums below their long-term average, suggesting that future interest rate increases could exert more upward pressure on cap rates.
Cap Rates Are Tight Across All Sectors
The continued increase in treasury yields has yet to have a significant effect on cap rates. Per Situs/RERC, retail saw the biggest change to cap rates, moving up 30 bps in the first quarter, while rates in all other sectors held within 10 bps of their fourth-quarter levels.
The 10-bps decline in industrial cap rates brought them to just 10 bps higher than their cyclical low. Office and apartment cap rates are above their cyclical troughs by 40 and 30 bps, respectively, but remain more than 50 bps tighter than their 10-year averages. Hotel cap rates remain unchanged in the first quarter at 8 percent, just below their 10-year average.
“Continued economic growth and incipient inflation are pushing interest rates up,” said Muoio. “While the current cap rate stability and the year-over-year increase in deal volume are positive signs, commercial real estate investors are faced with the legitimate concerns of higher costs of capital and tightening lending standards. While each property type and region provide a range of micro factors worth considering, it is understandable that this uncertainty has made investors cautious and pulled property pricing down on a year-over-year basis.”