Mixed Signals

The change in administration along with a rise in the 10-year Treasury did trigger a bit of a “wait and see” attitude in the commercial real estate industry at the end of 2016. “We are really getting some mixed signals right now in terms of what the fundamentals and what our clients say, be they investors or lenders,” says Steven R. Reynolds, CCIM, MAI, president of Pinnacle Associates, a Columbus, Ohio-based commercial real estate firm that provides valuation and consulting services. “There are so many moving parts right now that it is going to keep a lot of people guessing on where we think things will shake out this year.”

After seven years of growth, the majority of the industry agrees that the commercial real estate market is in a mature stage of the cycle. What is less certain is just how much longer the current cycle will last and what happens next.

There has been a myriad of factors that has extended the good times for the real estate market, and some of them were just dumb luck, notes John Bell, managing director of Capital Markets at Transwestern in Miami.

The Brexit vote a year ago came at a time when the U.S. was preparing to introduce rate hikes. However, the uncertainty that Brexit created in global markets prompted the Federal Reserve to keep interest rates low. The instability in foreign markets also made the U.S. even more popular for foreign investors.

The increased investor demand and continued low interest rates allowed 2016 to be a pretty stable year for investment sales and lending activity. That momentum is expected to continue in the first six months of this year, while the outlook for the latter half of 2017 and 2018 is less clear, according to Bell. “People are uncertain as to where the economy is going long-term. They are being cautious,” he says.

Impact of Higher Rates

Top of mind for the entire real estate industry is how capital markets will react to a rising interest rate environment. The 10-year Treasury started March at 2.36 percent, which represents a year-over-year increase of 50 basis points. Some analysts are predicting that the 10-year note could rise to 3 percent by the end of 2017 and 3.5 percent by mid-2018.

The Fed has indicated that it plans very modest increases this year that would potentially result in two or three increases to the short-term bank lending rate of 25 basis points each. Interest rates are rising, but the overall increase for the year is likely going to be benign and may coincide with stronger economic growth, notes Lisa A. Pendergast, executive director of the CRE Finance Council.

“For commercial real estate, the view is that any increase in rates and therefore cap rates, hopefully, will be  offset by greater demand for real estate and higher rents,” she says.

Moody’s/RCA Commercial Property Price Index shows that property prices climbed 9 percent in 2016. However, more recent research points to flat prices and cap rates that were either flat or slightly higher in fourth quarter of 2016, which is most likely due to a nearly 80-point spike in the 10-year Treasury that occurred during the quarter. According to the January Green Street Commercial Property Price Index, commercial property prices were up 3 percent compared to the past year, but flat in the past three months.

Higher interest rates are having a differing degree of impact on pricing and cap rates depending on asset type and quality, as well as location. For example, Green Street notes that industrial posted the strongest performance, with a 2-percent increase in property prices from November through January, compared to strip retail centers and lodging that were both negative at -3 percent and -1 percent, respectively, for that three-month period.

Potential Volatility

Many industry experts anticipate that higher capital costs will put an end to the long run of cap-rate compression. However, cap rates may hold steady in markets where there is still strong buyer demand.

“On a general level, most market participants have anticipated the rising rates for quite some time,” Reynolds says. As such, investors have already, at least partially, factored the effects into their investment decisions.

In addition, the strong investor appetite to acquire quality assets will help to sustain cap rates in some markets. “Buyers, at least for now, are willing to absorb a slightly lower return on equity, especially if they can acquire a quality asset,” Reynolds says.

Usually, rates go along with some level of economic growth or inflation, and that means that most businesses and properties are doing a little bit better, notes Jim Wilkie, CCIM, a senior vice president at Seacoast Commerce Bank in Magnolia, Texas. That being said, talk of higher interest rates ahead has borrowers keenly focused on capital costs and what that means for new investments. Borrowers are more concerned about what the rate is, what their rate options are, what the rate lock is, and how long they can lock that rate prior to closing, he says.

Seacoast Commerce Bank is one of the top Small Business Association real estate lenders in the country and is active throughout the western half of the U.S. Wilkie is seeing strong activity for all types of retail, medical, and industrial properties in his region, which includes Houston and central Texas. Few places in the commercial market lock a rate more than about five years, especially for small balance loans.

“I have not seen that quarter to half percent perceived increase in rate slow anything down,” Wilkie says. “At some level it will, but I have not seen that happening yet.”

Readily Available Capital

Overall, good liquidity from capital sources continues across the board, including bank and nonbank lenders such as life insurance companies, private equity funds, and Fannie Mae and Freddie Mac. CMBS also has adapted to new risk-retention rules that went into effect at the end of 2016 and is refilling its pipeline.

The looming wall of maturities has continued to shrink. While there may be some shake-out of lingering problem loans, most borrowers are finding ample capital for acquisitions and refinancing.

The Mortgage Bankers Association is projecting a steady pace of commercial and multifamily mortgage originations, with a growth rate of 4 percent to $537 billion in 2017, followed by another 2 percent increase in 2018 to $546 billion in originations.

Yet there are signs that lending and underwriting is tightening, notably on loans where lenders are concerned about oversupply or a mature phase of the cycle in a particular market. That does not mean those deals cannot get financed, but lenders are underwriting risk more cautiously, which may affect terms.

For example, a permanent loan on a hotel property may have been financed at a 70 percent loan-to-value ratio two years ago, and that same deal would be financed at 65 percent today with spreads that are a little wider if the lender is worried about the outlook, says Sean Deson, CCIM, senior managing director at Deson & Co. in Las Vegas, a boutique investment, mortgage, and merchant bank providing value-add bridge financing and permanent lending.

Slowing Construction Loans

Many borrowers are finding a more challenging climate for construction loans. Regulations requiring banks to hold more assets on their balance sheets to account for high volatility commercial real estate loans are impeding banks’ ability to lend on construction loans and also on some more stabilized assets, according to Deson.

Rates are still very good, but banks have pulled back on loan to values and recourse is a must. Some banks have “shut down” new construction and redevelopment financing activities other than for the best-of-the-best developers, he says.

Strong projects and sponsors are still finding access to capital, but most lenders are very cautious now, Bell notes. “Whatever they are doing or whatever they are lending on, they are going to scrutinize things a lot more than they did a year or two ago,” he says.

Another positive trend for the investment market is that there is still strong demand from foreign investors. “That pool keeps getting deeper and deeper in terms of the international buyers,” Bell says.

One of the wild cards ahead for commercial real estate is policy changes introduced by the Trump administration that could have both a direct and indirect effect on capital markets. President Trump has been very vocal on his intent to reduce regulations that are negatively affecting finance and business in general. That sentiment has been viewed favorably by capital markets, even though the details of those plans are still in the works.

The list of agenda items will include potential reforms to Dodd-Frank, as well as possible restructuring of Fannie Mae and Freddie Mac. Current legislation only provides funding for the two agencies through the end of 2017.

There has been speculation on what steps might be taken to keep funding in place or restructure those two agencies. Ultimately, the Trump administration has the potential to drive a lot of change in capital markets this year, according to Deson. “Good or bad, a lot of it is related to the administration and how it pushes certain agenda items,” he adds.