For over a half decade we’ve been in an up-cycle, and commercial real estate professionals are starting to wonder how much momentum is left before the inevitable happens and the market begins heading south; or to put it a little more colorfully, is the bull market headed for the abattoir?
If markets were interference free, they generally would run about seven to 10 years before turning, but government oversight and financial engineering has both extended cycles and crashed the economy. After a severe recession in the mid-2000s (felt most strongly in the commercial and residential real estate industries) there has been a long, sloping recovery. While it’s hard to read the tea leaves, it appears that parts of the commercial real estate market might have peaked.
“This up-cycle began in 2011 and so here we are seven years into a cycle that usually runs 10 years from peak to peak,” observes Jim Anthony, SIOR, CEO of Colliers International in the Raleigh-Durham office. “There are signs that the market is finally moderating, including a halt to cap rate compression and even some moderate cap rate rising.”
For the local view, SIOR Report checked in with commercial real estate professionals in cities in the Southeast, Midwest, and Southwest, and for a national perspective, Colliers International supplied some data points.
For our most recent data, as of the first quarter, Colliers reports office market fundamentals are at the strongest point in the cycle with peak occupancy and record rents, yet it also stated the market is cooling: occupancy is static, rental improvements are moderating, while investor strategies shift to suburban and secondary markets for higher yields.
Meanwhile, industrial markets continue to look so good, talk of the bull market going to pasture is almost non-existent. The U.S. industrial market held strong in the first quarter of the year, reports Colliers. Overall net absorption helped drop the vacancy rate to an all-time low, while demand kept new development solid and pushed asking rental rates to an all-time high.
For those on the transaction side of the business, Colliers was positively buoyant: nearly $14 billion in industrial assets changed hands in the first quarter of 2017, 3 percent higher than first quarter last year.
So let’s take a look at what all that means in a few local markets: two areas of the country red hot for growth, North Carolina and Arizona; and one with slower economic expansion, the Midwest.
Except for Florida, no other eastern state has experienced as much expansion as North Carolina. For folks in the commercial real estate business, tar-heel interest usually just meant Charlotte, but that has changed over the past decade with Raleigh getting a lot of new attention.
“Raleigh has gotten much buzz about being a burgeoning tech market and a destination for millennials,” says Anthony. “We have biotech and entrepreneurial software companies popping up. Job growth has been extremely positive and that has led to population growth.”
Just how buzzworthy is Raleigh?
“From 2014 through 2016, there were dramatic increases in the volume of investment sales in all property types,” says Anthony. “Apartments have traded hands furiously, industrial has been bid up to the highest levels in our market in terms of price per square foot and lowest cap rates, and Class A industrial buildings have seen sales at $80 a square foot. The best properties with the highest clear heights and best quality buildings haven’t sold for under $60 a square foot.”
Anthony adds, a few office transactions have achieved record prices and $330 a square foot has been recorded three times in our market. A mixed-use property that Anthony’s company sold, Pavilion East at Lakeview, went for $335 a square foot.
While that all sounds great, Anthony cautions Raleigh has seen the peak in pricing for this cycle and the velocity of investment sales have begun to slow. Sellers trying for record prices have been disappointed, which Anthony says, “tells you investors are not comfortable pushing the market up anymore. They are now anticipating moderating prices.”
In Raleigh-Durham, multifamily cap rates are still in the 4 to 5.5 percent range depending on class and location. There were some sub-4 percent sales back in 2015, but those are no longer happening, says Anthony. Office market sales are usually 6.5 to 8 percent cap rate, while industrial cap rates range from 6.5 percent for long-term good credit leases, up to 8 percent for lower class older properties.
I’ve been through a number of cycles,” says Anthony. “I don’t see any imminent reasons why there would be a crash, but we are definitely going to see moderation in pricing.”
Just a two and a half hour drive to the southwest sits North Carolina’s biggest city, Charlotte, which, unlike Raleigh, expects good times in commercial real estate to continue.
“The bull market is not nearing an end,” says John Culbertson, SIOR, CRE, CCIM, the managing partner for Cardinal Partners in Charlotte. “Everyone is looking at multifamily where there are signs of slowing, but indications suggest not enough housing and a lot of smart developers are continuing to look for new apartment sites.”
Charlotte dominates Mecklenberg County, which for the past 10 years, has been one of the fastest growing metro areas in the country. Home to Bank of America and other large banks, Charlotte was resilient during the downturn. The big surprise is that Charlotte is also the entry point for the burgeoning automotive industry in nearby South Carolina.
“The industrial sector is hot,” says Culbertson. “Rents continue to rise and there is a lot of development that is in the pipeline. I anticipate continued growth in the industrial sector here because we are an economy driven by the momentum of our own growth, which continues to have long-term growth projections for distribution. E-commerce is also expanding, accounting for 9 percent of total industrial absorption right now.”
Charlotte is a more regional e-commerce industrial market for companies trying to get same-day or next-day delivery. As a result it gets few 1 million-square-foot facilities; most distribution buildings are in the 250,000 to 500,000-square-foot range.
“Occupancy rates have been at record levels (93.1 percent occupancy for Class A space) and absorption is the highest since 2005,” says Culbertson. “Rents are up 15 percent over the past three years. Market rents for Class A is $4.65 a square foot. Over the next six months, vacancies will increase as new products are being brought on the market. Rental rates should remain steady.”
Culbertson concludes, “The easy money for investors has been made, but there is still money to make.”
The fastest growing county in the country is not in North Carolina, but in Arizona. Maricopa County, home to the sprawling Phoenix metro, takes the title, and as can be expected the commercial real estate market has been good. Peter Batschelet, principal and industrial specialist with Lee & Associates in Phoenix, doesn’t expect that to change any time soon, especially in regard to industrial.
“If the country continues at a 1.5 percent or 1.9 percent GDP growth that’s good, we’ll have another 18 to 24 months without a hiccup – provided all the external factors remain stable,” says Batschelet.
As for Phoenix, Batschelet comments, “we are not blowing the national markets out of the water, but we are exceeding every bar being set right now. As wages improve in Phoenix (growing 50 percent higher than national average) more people move here.”
In regard to industrial, the sector is diverse with big transportation, manufacturing, and construction occupancies. “We have an extreme amount of demand and little supply,” says Batschelet. “Contractor yards – they don’t exist; manufacturing buildings are hard to find; and in bulk distribution there are few opportunities. Supposedly there are 3 million or 4 million square feet of leases circling Phoenix right now.”
Phoenix is a big industrial market with 350 million square feet of space. Occupancy for the whole market stands at 9.6 percent. “We are trending in the right direction,” says Batschelet. “If we land a few of these bigger deals our vacancy will drop very quickly. We still have speculative building going on.”
Phoenix also boasts a lot of incubator product, meaning 2,500 square feet to 5,000 square feet. Generally, those vacancies are less than 5 percent.
“We see all these smaller companies coming out of the woodwork,” says Batschelet. “When you see these smaller spaces being filled up, that is a great sign.”
Phoenix, Charlotte and Raleigh have benefitted from capital moving from the core cities of New York, Boston, and San Francisco to secondary markets as investors look for better yield. Capital has also pushed into the middle of the country and a later beneficiary has been the Midwest.
“Across the entire Midwest we have enjoyed enormous investment interest,” says Mark Kolsrud, SIOR, CPM, a senior vice president at Colliers in Minneapolis. “We have attracted a lot of displaced capital, which has moved from core markets because of ridiculously low returns. Cities like Minneapolis have seen new investments because investors just can’t satisfy their yield needs in these other markets.”
The difference in returns on a core asset, whether it is industrial or office, can be 150 bps, between Minneapolis and primary cities.
Kolsrud’s company boasts buildings for sale in 14 states across the Midwest. For example, it has a five building industrial portfolio in the Minneapolis market that’s 820,000 square feet. “We are getting incredible interest from local, national, and international institutional buyers,” Kolsrud says.
Foreign capital has been chasing two Midwest, multi-state aggregations that Colliers is brokering, a portfolio of 24 buildings, all single-tenant net lease and another portfolio of 13 single-tenant, net-lease buildings.
“We have more deals today than last year at this time,” Kolsrud says.
He is very optimistic for the near future. “In the second-tier markets things will get even better. Through the next 12 months we’ll see the current trend keep going. A lot of product sitting on the sidelines is poised to hit the market so I expect good activity.”
The only negative on Kolsrud’s crystal ball is that there might be some slowdown in core assets such as CBD office buildings and larger, high-ceiling, industrial portfolios as a lot of those have already sold.”
In June, the Wall Street Journal ran a story with the title “A Turning Point for Commercial Property,” citing softening sales, loan standards tightening, loan growth slowing, and stocks lagging. The question for investors, the article concluded was, “how fully these risks are appreciated now?” Or, to express the sentiment differently, which way will the bull market turn?
By: Steve Bergsman (SIOR)
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