Daily market intelligence on mortgages, equity raising, investment sales, and CMBS.

Tuesday, 14 January 2020

CRE Not Done Growing (Quite) Yet

It's been said that 2020 would usher in upward pressure on capitalization rates and downward pressure on property values. However, that does not appear to be the case.

By Jamie Woodwell

The commercial real estate and finance markets have been on a long-running roll. Since the end of the Great Financial Crisis, property rents and net operating incomes generally have increased, while capitalization and mortgage rates have declined. Meanwhile, property values, sales transactions, mortgage originations and mortgage debt outstanding generally have increased.

What's not to love?

Last year at this time, we were anticipating this long-running period of growth would be transitioning to a period of "plateau," with rising interest rates putting upward pressure on cap rates and slowing the long-term increase we've seen in property values. We weren't alone. Economists surveyed by the Wall Street Journal, the Federal Reserve Bank of Philadelphia and others largely expected rates to increase from the 3 percent-plus levels of 2018. And surveys of institutional real estate investors anticipated that while property income returns would stay strong, and even grow, appreciation would slow - and in some cases, reverse course.

That was then, this is now.

Instead of increasing, interest rates fell further, with the 10-year Treasury dropping to an average of 1.81 percent in November 2019 from 3.12 percent a year earlier. Many measures of cap rates have largely held steady in the months since, but if the average cap rate for apartment buildings (5.5 percent for most of the year, according to Real Capital Analytics) fell by the same 131 basis points that long-term Treasury rates fell, that would imply a 24 percent increase in property values - without accounting for the impact of any parallel increases in property incomes.

So instead of upward pressure on cap rates and downward pressure on property values, we enter 2020 with the potential of downward pressure on cap rates and (further) upward pressure on property values.

What a difference a year makes.

In a recent paper, Where from Here? Trends in Commercial/Multifamily Real Estate Finance Markets, we identified five key issues - including the ones driving the trend described above - that will shape the coming year in commercial real estate and finance.

Jobs

On a seasonally adjusted basis, the United States has added jobs every month since February 2010 - bringing a total of 22 million additional positions during that period. That growth has helped support office and other markets, but has been muted by the ever-more efficient use of space by occupiers, teleworking arrangements and other trends. Employment growth has been slowing over recent years and months, and the tight labor market may constrict that growth further. The outlook for job growth - and the demand it brings to the office, retail, multifamily and other property sectors - remains positive, but it is highly likely the pace of that growth may slow.

Households

Four years ago, the Mortgage Bankers Association published a paper, Housing Demand: Demographics and the Numbers Behind the Coming Multi-Million Increase in Households, which predicted a growth of roughly 1.6 million households per year between 2014 and 2024. U.S. Census Bureau numbers show that in both 2017 and 2018, the country added 1.6 million households, and that between the third quarter of 2018 and third quarter of last year, 1.3 million households were added. Equally important as the overall level of growth is the composition of that growth. After more than 10 years of increases, the population age of 25 to 29 (a key renting demographic) will decline between 2020 and 2025. The population aged 40-44 (a key home-buying demographic) will turn from decline to growth, and the population aged 75-plus will surge. Those changes will affect the aggregate demand for housing, shopping and other uses of space, and equally important, the composition of that demand.

Consumer

The U.S. consumer is the life-blood of the U.S. and world economies. In the third quarter of 2019, personal consumption expenditures accounted for $14.7 trillion, or 68 percent, of the $21.5 trillion U.S. economy. Job, wage and household growth in recent years have all supported that consumption, and retail sales (excluding motor vehicle and parts dealers) increased 2.6 percent between the 12-month period ending November 2019. More of that consumption is going online (11.2 percent as of the third quarter), but U.S. consumers remain an essential element of commercial real estate demand and the economy as a whole.

Consumer debt-service levels are at their lowest since the Fed began tracking them in 1980, so consumers should be in good shape for whatever turns the economy brings, but their continued engagement is essential.

Interest Rates

Interest rates have defied expectations for more than a decade - with economists and investors anticipating that economic growth and tight labor markets would push long-term rates higher. Instead, rates have trended downward. Commercial real estate can be heavily influenced by the direction of rates - with the availability and cost of mortgage financing a key input to investment and development decisions - and with cap rates, which may move in sympathy with base interest rates, affecting the underlying value of commercial properties. The result can be shrinking cap rates (and rising property values) when rates drop and increasing cap rates (and declining property values) when rates rise. New expectations that rates may remain "lower for longer" could be a boon for commercial real estate values, as well as transaction volumes.

Search for Yield

Amid all the trends outlined above, one key characteristic of today's market is the search for yield. Investors have a strong appetite for CRE and CRE finance investments. They've also had a willingness to take on increased risk in the face of low yields. CMBS bond pricing is perhaps the clearest example of this, with the credit curve for CMBS (a line showing the increased yield investors demand to take on additional risk) falling and flattening—meaning investors are requiring less additional yield to invest in riskier bonds than they had in the past. The two key takeaways should probably be a) investors' comfort with CRE debt as an investment and b) the difficulty investors face in the current broad investment markets in finding higher yielding options.

Conclusion

CRE and finance markets are entering 2020 with momentum and a still strong foundation. As we move from a period of almost exclusively tailwinds to one in which some headwinds will likely begin to be seen, it appears that CRE's 10-year run of growth is not done (quite) yet.

Jamie Woodwell is vice president of commercial real estate research at the Mortgage Bankers Association.

 

By Jamie Woodwell

The commercial real estate and finance markets have been on a long-running roll. Since the end of the Great Financial Crisis, property rents and net operating incomes generally have increased, while capitalization and mortgage rates have declined. Meanwhile, property values, sales transactions, mortgage originations and mortgage debt outstanding generally have increased.

What's not to love?

Last year at this time, we were anticipating this long-running period of growth would be transitioning to a period of "plateau," with rising interest rates putting upward pressure on cap rates and slowing the long-term increase we've seen in property values. We weren't alone. Economists surveyed by the Wall Street Journal, the Federal Reserve Bank of Philadelphia and others largely expected rates to increase from the 3 percent-plus levels of 2018. And surveys of institutional real estate investors anticipated that while property income returns would stay strong, and even grow, appreciation would slow—and in some cases, reverse course.

That was then, this is now.

Instead of increasing, interest rates fell further, with the 10-year Treasury dropping to an average of 1.81 percent in November 2019 from 3.12 percent a year earlier. Many measures of cap rates have largely held steady in the months since, but if the average cap rate for apartment buildings (5.5 percent for most of the year, according to Real Capital Analytics) fell by the same 131 basis points that long-term Treasury rates fell, that would imply a 24 percent increase in property values—without accounting for the impact of any parallel increases in property incomes.

So instead of upward pressure on cap rates and downward pressure on property values, we enter 2020 with the potential of downward pressure on cap rates and (further) upward pressure on property values.

What a difference a year makes.

In a recent paper, Where from Here? Trends in Commercial/Multifamily Real Estate Finance Markets, we identified five key issues—including the ones driving the trend described above—that will shape the coming year in commercial real estate and finance.

Jobs

On a seasonally adjusted basis, the United States has added jobs every month since February 2010—bringing a total of 22 million additional positions during that period. That growth has helped support office and other markets, but has been muted by the ever-more efficient use of space by occupiers, teleworking arrangements and other trends. Employment growth has been slowing over recent years and months, and the tight labor market may constrict that growth further. The outlook for job growth—and the demand it brings to the office, retail, multifamily and other property sectors—remains positive, but it is highly likely the pace of that growth may slow.

Households

Four years ago, the Mortgage Bankers Association published a paper, Housing Demand: Demographics and the Numbers Behind the Coming Multi-Million Increase in Households, which predicted a growth of roughly 1.6 million households per year between 2014 and 2024. U.S. Census Bureau numbers show that in both 2017 and 2018, the country added 1.6 million households, and that between the third quarter of 2018 and third quarter of last year, 1.3 million households were added. Equally important as the overall level of growth is the composition of that growth. After more than 10 years of increases, the population age of 25 to 29 (a key renting demographic) will decline between 2020 and 2025. The population aged 40-44 (a key home-buying demographic) will turn from decline to growth, and the population aged 75-plus will surge. Those changes will affect the aggregate demand for housing, shopping and other uses of space, and equally important, the composition of that demand.

Consumer

The U.S. consumer is the life-blood of the U.S. and world economies. In the third quarter of 2019, personal consumption expenditures accounted for $14.7 trillion, or 68 percent, of the $21.5 trillion U.S. economy. Job, wage and household growth in recent years have all supported that consumption, and retail sales (excluding motor vehicle and parts dealers) increased 2.6 percent between the 12-month period ending November 2019. More of that consumption is going online (11.2 percent as of the third quarter), but U.S. consumers remain an essential element of commercial real estate demand and the economy as a whole.

Consumer debt-service levels are at their lowest since the Fed began tracking them in 1980, so consumers should be in good shape for whatever turns the economy brings, but their continued engagement is essential.

Interest Rates

Interest rates have defied expectations for more than a decade—with economists and investors anticipating that economic growth and tight labor markets would push long-term rates higher. Instead, rates have trended downward. Commercial real estate can be heavily influenced by the direction of rates—with the availability and cost of mortgage financing a key input to investment and development decisions—and with cap rates, which may move in sympathy with base interest rates, affecting the underlying value of commercial properties. The result can be shrinking cap rates (and rising property values) when rates drop and increasing cap rates (and declining property values) when rates rise. New expectations that rates may remain "lower for longer" could be a boon for commercial real estate values, as well as transaction volumes.

Search for Yield

Amid all the trends outlined above, one key characteristic of today's market is the search for yield. Investors have a strong appetite for CRE and CRE finance investments. They've also had a willingness to take on increased risk in the face of low yields. CMBS bond pricing is perhaps the clearest example of this, with the credit curve for CMBS (a line showing the increased yield investors demand to take on additional risk) falling and flattening—meaning investors are requiring less additional yield to invest in riskier bonds than they had in the past. The two key takeaways should probably be a) investors' comfort with CRE debt as an investment and b) the difficulty investors face in the current broad investment markets in finding higher yielding options.

Conclusion

CRE and finance markets are entering 2020 with momentum and a still strong foundation. As we move from a period of almost exclusively tailwinds to one in which some headwinds will likely begin to be seen, it appears that CRE's 10-year run of growth is not done (quite) yet.

Jamie Woodwell is vice president of commercial real estate research at the Mortgage Bankers Association.




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Data Digest

 

CMBS DELINQUENCY VOLUME

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CMBS SPECIAL SERVICING VOLUME

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Top Bookrunners Domestic, Private-Label CMBS - 2017
Investment Bank #Deals Vol$mln MktShr%
Goldman Sachs 17.59 11,819.34 13.68
JPMorgan Securities 14.52 10,968.11 12.70
Citigroup 12.04 10,012.71 11.59
Wells Fargo Securities 14.02 9,936.06 11.50
Deutsche Bank 12.55 9,879.74 11.44

 

RCA CPPI

 

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CMBS 2.0 Spreads

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Top CMBS Loan Contributors - 2017
Lender #Loans Vol$mln MktShr%
Goldman Sachs 146.89 11,719.34 13.63
JPMorgan Chase Bank 117.68 10,114.14 11.76
Deutsche Bank 198.48 9,689.97 11.27
Morgan Stanley 166.18 8,539.78 9.93
Citigroup 199.05 8,088.24 9.41

 

 

 

REITCafe

  • Challenging Retail Environment Weights on REITs
    Mixed economic news is weighing on retail markets, pushing REIT performance down in 2015. This week, the National Retail Federation announced that back-to-school spending is expected to be down 9.3% in 2015. This news came on the heels of a report from the Commerce Department stating that retail sales declined 0.3%...
     
  • US REITs Feeling Effects from Turmoil in Greece and China
    International economic forces have taken center stage this week, affecting both US stock markets and REITs. The crash in the Chinese stock market and ongoing concerns about the future of Greece in the eurozone drove markets down during the first half of the week. REITs fared better than the overall market...

  • What Does Increased Construction Mean for Apartment REITs?
    REITs so far this year have raised $17.1 billion of capital through the sale of unsecured notes, bringing the total raised over the past two and a half years to just more than $75 billion. That’s more than they raised during the previous five years. The massive volume shouldn’t be a surprise as it comes while the yield from 10-year Treasury bonds, the benchmark...
shouldn’t be a surprise as it comes while the yield from 10-year Treasury bonds, the benchmark against which most REIT’s price their bonds
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