September 24, 2014
U.S. Real Estate Chart Book: Pricing Questions
By: Paige Mueller, Managing Director, Todd Castagna, Vice President, and CJ Faulwell, Associate
RCLCO U.S. Real Estate Outlook - Pricing Questions
Have we already or are we rapidly approaching the peak in this cycle's real estate values? Clients of the firm have begun to raise this question during the past few months as asset values continue to rise and cap rates continue to fall. With construction ramping up in most markets and across all major property types, can there still be enough upside to warrant continued investment in real estate during this cycle? Are we in 2003, 2005, or 2007 real estate market conditions? Indeed, dry powder continues to amass to record levels as investors debate these questions.
Cap rates nationally for most major property types are now lower than at any point in the last real estate cycle. Led by apartments (which in some core markets are at sub-4% cap rates) and CBD office, investors have begun to move up the risk spectrum in order to enhance yield. Heavy construction has begun in several MSAs around the country--with Austin, Denver, San Jose, and Suburban Virginia all in the midst of constructing over 5% of their current apartment inventory (even 1-2% would be considered a robust pipeline). This construction pipeline is likely to slow rent growth and stall occupancy growth in many prime apartment locations nationwide over the next two years.
Although some parts of the real estate market are facing headwinds via uncertain supply/demand fundamentals, we believe that significant tailwinds remain for the real estate market overall that indicate that we have likely not peaked but could be poised for continued growth in the short term. In the second quarter of 2014, banks continued to loosen lending standards at a moderate pace while the CMBS market--on pace to eclipse its 2013 issuance--continued its recovery. Real GDP growth, while unspectacular, is poised for its fifth straight year of near 2%+ growth, and most regions of the country are expected to benefit--but particularly those regions where economies are tied to technology and energy. With jobs steadily returning, office, retail, industrial, and single-family homes should all benefit. Spreads between cap rates and 10-year treasuries remain wider than historical averages. When spreads have been at these levels historically, the next-three-year NCREIF returns have averaged 10%+ annually. For most property types, our analysis indicates that even a 100 basis point increase in Treasury rates from current levels would not put significant pressure on cap rates (with the exception of apartments and CBD office).
Non-major markets have performed as well as major markets since 2011 and this trend has continued throughout 2014. In fact, major market pricing has eclipsed 2007 peak pricing by over 8%, while non-major market pricing is still 12% lower than its 2007 peak. Assets in suburban or tier 2-3 markets with good fundamentals can still be acquired at well below replacement cost.
We are advising clients to remain patient, as good investment opportunities with sound fundamentals still exist, particularly for clients who can take construction risk, and real growth even for core properties is likely to persist in the short term. However, portfolios should be reviewed for property exposure to competition from new construction, particularly in apartment and prime CBD office markets. Additionally, investors should have a risk monitoring system in place, including review of interest rate risk, for example, in the form of variable rate loans and refinancing needs.
RCLCO provides real estate economics and market analysis, strategic planning, management consulting, litigation support, fiscal and economic impact analysis, investment analysis, portfolio structuring, and monitoring services to real estate investors, developers, home builders, financial institutions, and public agencies. Our real estate consultants help clients make the best decisions about real estate investment, repositioning, planning, and development.
RCLCO's advisory groups provide market-driven, analytically based, and financially sound solutions. RCLCO's Institutional Advisory Group produced this newsletter. Interested in learning more about RCLCO's services? Please visit us at www.rclco.com/institutional.