NEW YORK CITY—Even as demand and liquidity remain healthy and commercial property fundamentals still trend positive for the most part, both sales volume and growth in pricing and leasing metrics continue to decelerate, says Keefe, Bruyette & Woods. This could eventually have an impact on comps.
Citing data from Real Capital Analytics, KBW points out that transaction volume through October was down 7% year over year in terms of value and 1% in the number of properties that traded. In the third quarter, the decline was 5% for value, although the number of properties that traded was up by 3.5% Y-O-Y.
By property type, the year-to-date decline includes 7% for office, 9% for apartments, 19% for retail and 24% for hotel. Conversely, industrial volume is up 25%, reflecting the growth of e-commerce. Single-asset volume is down 7% YTD in value. Markets with the most significant volume declines include New York City, Chicago, Miami, San Francisco and Denver while Washington, DC. Houston, Dallas, San Jose, Charlotte and the Inland Empire have seen increases.
“We believe the decline reflects the impact of elevated CRE pricing, modestly higher interest rates, political uncertainties and some hesitation on the part of buyers/sellers regarding perceived late-cycle risk,” according to KBW's report. The firm's analysts continue to expect that volume will be down between 5% and 10% for full-year 2017. “We believe increased loan originations are a partial offset as some property owners look to take advantage of strong capital markets liquidity and embedded price appreciation in lieu of property sales.”
Even so, says KBW, cap rates have held steady—growing an average of nine basis points Y-O-Y—while pricing movement has ranged from minus 1% to positive 8% depending on the index. CRE prices are up 7% Y-O-Y, 6.7% YTD and 1.4% over the past three months based on RCA, Green Street and CoStar, according to the report.
Certain indices, such as Green Street and CoStar, suggest recent outperformance in secondary markets and lower-quality commercial real estate over primary markets and higher-quality CRE. “We believe this divergence reflects a shift in incremental investor demand from primary to secondary markets due to more attractive relative yields as primary markets have experienced stronger price appreciation to-date through this cycle,” the report states.
Looking at CRE metrics, KBW estimates an average US vacancy rate of 6.6% for Q3, down five bps both Y-O-Y quarter-over-quarter. On a Y-O-Y basis, vacancy declined for office and industrial, while increasing for retail and apartments.
Citing RCA analysis of property cash flow data provided by the National Council on Real estate Investment Fiduciaries, KBW says that Q3 NOI increased 2.2% Y-O-Y for commercial properties and 4.5% Y-O-Y for apartments on a per-square-foot basis. This represents a slight acceleration from Q3 2016's 1.0% NOI growth for commercial properties and a deceleration from 6.7% for apartments in the year-ago period.
With the Senate poised to enact a sweeping overhaul of the tax code Tuesday evening, KBW analysts said they saw a “mostly positive impact” for CRE. “Lower tax rates and a simpler tax code should stimulate business and consumer demand, eventually producing stronger property NOI, according to KBW. “On the other hand, limitations on some deductions, such as interest expense and state and local taxes, could negatively impact after-tax income absent improved NOI.”
Although REITs don't pay taxes on taxable earnings, KBW says their valuations may be positively affected by the tax reform package anyway, based on the 20% deduction on qualified dividends on pass-through income. “We estimate the effective tax rate on REIT dividends will decline to 28-29.6% from 35-39.6% previously using the top two marginal tax rates, resulting in an increase in after-tax dividend yields depending on the REIT's dividend yield and one's marginal rate and income.”
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Paul Bubny
Paul Bubny is managing editor of Real Estate Forum and GlobeSt.com. He has been reporting on business since 1988 and on commercial real estate since 2007. He is based at ALM Real Estate Media Group's offices in New York City.
