The fourth quarter is shaping up to be the cap on a banner year for the commercial real estate (CRE) market. Transaction activity has accelerated meaningfully, buoyed by an abundance of capital and a dearth of yield opportunities in today’s market. Property price appreciation has followed suit, rising to its highest level in 15 years.1 With government policy having acted as a bridge across troubled waters throughout the pandemic, the CRE market appears to be entering a new expansion phase much more quickly than many thought possible just a year ago. CRE enters this expansion with considerable momentum, but the new cycle also comes with its own challenges—some familiar, others unique to the current climate.
Key takeaways
- Despite increasing headwinds, economic fundamentals in the U.S. remain supportive.
- Transaction volumes and property price growth are illustrative of a strong market.
- Dispersion between sectors and geographies has rarely been greater; the full impacts of the pandemic on property utilization will take years to comprehend.
In last quarter’s outlook, we focused on a rapid improvement in fundamentals and investor sentiment within the CRE market but observed that transaction activity had yet to fully rebound. That all changed in the third quarter as volume growth accelerated, putting 2021 within striking distance of setting a new annual activity record.1 This is illustrative of how different the current environment is from the Global Financial Crisis (GFC) and subsequent recovery. The nature of the COVID downturn forced the U.S. government to deploy all available fiscal and monetary instruments in their toolkit, in effect short-circuiting the downturn and any potential aftershocks to the financial system. This helped bridge the CRE market to a new cycle that is moving much more quickly than the most recent one. While the rapid economic rebound is undoubtedly positive, it does come with its own set of challenges. There are numerous cyclical and secular questions for certain CRE sectors that will continue to unfold in the upcoming quarters and years.
Just 18 months out from the nadir of a deep recession, the state of the U.S. economy appears strong. Current expectations are for Q4 U.S. GDP growth to clock in at 5.1% annualized, with full-year 2021 growth finishing near 6%, which would represent the best year for growth since 1984.2 While various factors including the delta variant caused some moderation in growth expectations during Q3, it is important to keep in context how strong these rates of change are. Labor markets have staged a rapid, albeit uneven rebound, and household balance sheets
remain strong.
As encouraging as the recovery from COVID has been, the CRE market’s foray into the next expansion will bring its own challenges. The financial scarring brought on by the GFC made for a long, drawn-out recovery, with lenders and investors reticent to re-enter the market. The primary considerations in our current cycle are much different and include elevated inflation brought on by persistent supply chain issues and a Federal Reserve that already appears prepared to take a more hawkish stance.
Past rate hike cycles have tended not to impact sales volumes but have correlated with a modest increase in mortgage rates and a moderation in property price growth. We also tend to see performance dispersion between sectors widen as the Fed tightens policy, though dispersion is already at a record high today.1
Capital markets activity has increased markedly in the past six months, lagging the economic recovery by about a quarter. Transaction volume trends tend to react slowly to economic fundamentals, as it takes time for buyers and sellers to agree on market-clearing prices in an illiquid and heterogeneous asset class. Still, CRE volumes have returned to the pre-COVID pace of roughly $150 billion per quarter in just 18 months, a full five years quicker than the post-GFC market. Property prices continue to climb higher, with August’s 13.5% year-over-year price growth the highest level since 2005. With fixed income yields low, CRE cap rates at 5%–6% appear attractive to many investors.1
Supporting the uptick in acquisition activity has been the debt market, which has seen more lenders enter the fray over the past few months. Commercial mortgage-backed securities (CMBS) issuance, which has flagged since the start of the pandemic, roared back in recent quarters driven by record CRE collateralized loan obligation (CLO) issuance. Banks, which had also pulled back, have loosened standards for borrowers as loan demand increases. Even as the market becomes more competitive, lending standards remain healthy. Loans are being underwritten at average loan-to-values (LTV) of around 60% and low mortgage rates keeping debt service coverage near all-time highs.1 Delinquencies, which are concentrated in the retail and hotel sectors, have continued to decline gradually.3
As we’ve discussed, the prevailing theme within CRE (and indeed, in many markets) has been dispersion. The office, retail and hotel sectors remain, to various extents, bound to the path of the pandemic and pandemic-driven trends. In contrast, multifamily and industrial have seen their positive secular trends accelerated by COVID. Investor preferences have shifted along with consumer preferences, and these two sectors now comprise nearly 60% of all CRE sales activity, compared to 40% just six years ago.1
In our view, the pandemic has further bifurcated the CRE market into cyclical sectors (office, retail and hotel) and secular sectors (apartment and industrial). Importantly, there are certain secular components within a broader cyclical sector—for example, life sciences and medical office. Investors are also increasingly viewing the relationship between these two broad groupings of CRE sectors as a proxy for risk appetite. For example, looking at public REIT returns, relative performance between the cyclical and secular sectors closely tracks that
of growth and value stocks.2
We believe the CRE market is poised for a strong Q4. The early expansion phase is historically robust for CRE as financing becomes more available, fundamentals continue to strengthen, and interest rates remain supportive. The quarter could get an added boost should the delta variant-driven COVID wave continue to wane. Given this backdrop, we anticipate seeing activity begin to broaden into lagging sectors like retail and office as investors gain more clarity around fundamentals. With that said, we expect significant dispersion to remain from both a sectoral and geographical perspective. As this market cycle moves quickly into an expansion phase, the biggest challenge for investors continues to be assessing the durability of pandemic impacts on the CRE market.
