East West Commercial Real Estate

As Reported by: Scott Cianciulli / Ray Yeung of Brainerd Communicators on June 22, 2011

Average overall cap rates decrease in 27 of the survey’s 31 markets

Despite a skittish US economy, most commercial real estate investors remain upbeat and cautiously optimistic about the industry’s future, with very few being dissuaded from eagerly acquiring assets and seeking opportunities across all commercial real estate sectors. In fact, many investors are aggressively pursuing deals as they continue to see signs that the industry’s overall fundamentals are stabilizing and even improving in certain sectors and regions, according to the second quarter 2011 findings of the PwC Real Estate Investor Survey, released today.

According to the report, rental rates remain below peak levels for most property types and regions, although there is a sense among surveyed investors that they have stabilized. This quarter, the average market rent change rate assumption reported by Survey investors increased in 25 of the report’s 31 markets, further demonstrating investors’ sense that an ongoing, albeit slow, recovery is occurring.

“The trajectory of the commercial real estate industry’s recovery is largely dependent on the health of the US economy.  The ability of the economy to add jobs instills optimism in both businesses and consumers,” said Mitch Roschelle, partner, US real estate advisory practice leader, PwC. “Despite recent disappointing labor reports and falling home prices, commercial real estate investors continue to look to the positive aspects  of  the industry as they remain cautiously optimistic that the recovery path will continue.  The significant lack of new supply over the past several years serves as the catalyst of the ongoing recovery. As tenant demand continues to grow, positive absorption has begun to drive rents up.  The prospects of rent growth have driven much of the aggressive bidding by investors in certain top-performing markets.”

“In addition to improving fundamentals, the volatility of the stock market, weakening currencies, and the low fixed income coupons have fueled a rotation into hard assets such as precious metals, commodities and commercial real estate,” Roschelle added. Most institutional investors, particularly pension funds, are targeting top-performing assets in strong markets with some surveyed participants indicating that they’re concentrating on opportunistic plays. Moreover, there are a growing number of distressed assets that are trading as bank regulators put more pressure on lenders to deal with nonperforming loans – yet another sign that the US commercial real estate industry is on the mend.

Office Sector Leads Quarterly Overall Cap Rate Decline

The average overall capitalization (cap) rate, the initial return anticipated on an acquisition and a reflection of an investment’s anticipated ownership risk, decreased in 27 of the 31 surveyed markets, increased in three, and held steady in one during the second quarter 2011. The steepest declines occurred for the national central business district (CBD) and national suburban office markets, as well as the Dallas office market, where the average declined 51 basis points.

While the apartment sector has led the industry’s recovery and has experienced continued cap rate compression over the past 18 months, the office sector was slow to rebound due to a sluggish labor market. However, as employment has improved and business profits have risen, the sector has gained traction and, as a result, more investors are focused on acquiring office buildings, causing overall cap rates to decline – especially for core assets in top markets. Over the next six months, the Survey found that participants expect overall cap rates to either hold steady or decline due to strong buyer interest, low interest rates, and a positive economic outlook.

According to Survey findings, the Manhattan office market’s average overall cap rate has fallen below 6.00 percent for the first time since 2008 and represents the lowest average of the 18 individual office markets in the Survey, reflecting investors’ confidence in Manhattan’s ability to lead the recovery and rebound faster and stronger than most other metro areas. An optimistic outlook for Manhattan is also reflected when reviewing the Survey’s average market rent change rate assumptions, or what investors foresee rental rates increasing by over the next year. When comparing this key indicator for the Manhattan office market to the Survey’s national CBD office market, it is clear that investors in Manhattan were quite aggressive with their rent expectations during the expansion, but became very pessimistic during the recession.

Investors are back on track with pre-recession growth expectations for Manhattan, as well as the national CBD market.  As shown in the accompanying chart, average market rent change rate assumptions in the Manhattan office market have steadily climbed back since the lowest point during the recession in third quarter 2009, when it was hovering around -6.50 percent, up to 3.00 percent in the second quarter 2011.  The national CBD office market, which was at -2.00 percent in fourth quarter 2009, is now at 1.39 percent. These trends support the notion that investor sentiment is improving in CBD cores, especially top-performing markets.

“Surveyed investors are treading carefully as they realize that troubles could arise if interest rates rapidly increase at the same time and a large pool of commercial maturities peaks over the next two years,” stated Susan Smith, editor-in-chief of PwC’s quarterly survey. “If those factors play out, overall cap rates would likely rise and negatively impact property values. Luckily, though, most of the participants have told us that they maintain an optimistic outlook for now, even if cautiously so.”