The ULI Real Estate Consensus Forecast, issued biannually, which surveys 46 economists and analysts, predicts strong demand and value for real estate for the next three years.
During a ULI members–only discussion based on the forecast, Anita Kramer, senior vice president for the ULI Center for Capital Markets and Real Estate, said, “Survey participants are predicting three more years of fairly favorable real estate conditions in the U.S.”
According to the panelists, real estate continues to offer strong relative value compared with other investments, and fundamental demand for real estate is also quite strong, without much threat from new construction for most property types. “We are still relatively early in the cycle both for underwriting and market fundamentals,” said panelist Suzanne Mulvee, a senior real estate strategist for CoStar Portfolio Strategy.
High Prices for Prime Properties
Property prices are expected to rise 10 percent in 2015, as measured by the Moody’s/Real Capital Analytics Commercial Property Price Index, according to the consensus. That is close to the 11 percent increase to the index in 2014. It also represents a big change from the increase expected just six month ago, when an increase of just 6 percent was predicted for 2015.
Real estate prices will also rise relative to the income produced at the properties, driving capitalization rates down to 5.3 percent in 2015 on average as measured by the National Council of Real Estate Investment Fiduciaries (NCREIF), according to the consensus. That is down from 5.5 percent in 2014. Cap rates, which represent income as a percentage of property prices, will rise to 5.6 percent in 2016 and 5.9 percent in 2017, according to the consensus.
“You are going to see capital continue to flow into real estate and continue to put downward pressure on cap rates . . . particularly in the gateway markets,” says Will McIntosh, executive managing director and global head of research for USAA Real Estate Company.
That is a big change from the consensus just six month ago, when the experts surveyed by ULI said that average cap rates would jump back up to 6 percent in 2015 and stay at 6 percent in 2016. Strengthening fundamentals and weaker prospects for the rest of the world economy are drawing more cash to U.S. commercial real estate.
Much of this investment comes from overseas, including sovereign wealth funds and high-net-worth individuals and families focused on prime properties in gateway U.S. cities. These investors are part of the reason for high-profile deals with cap rates as low as 3 percent. “They are looking at this as long-term preservation of capital as opposed to any type of relative value,” says Lisa Pendergast, managing director and cohead of commercial mortgage–backed securities (CMBS) strategy and risk for Jefferies & Company.
“We are seeing aggressive buying from family offices,” says Tim Wang, director and head of investment research for Clarion Partners. “They are taking 20-year or even 50-year time horizons, so when they are underwriting, they don’t care about low cap rates.”
Properties in secondary markets also will benefit from the boom in investment. In some cases, international investors partner with firms in the United States to buy properties outside of their usual comfort zones in gateway cities. “We will even see capital moving out into the secondary market areas where prices will actually start to pick up as well,” says McIntosh.
Low Interest Rates, Looser Underwriting
Lenders will continue to offer very low interest rates to borrowers. That is largely because the benchmark yield on ten-year Treasury bonds will rise only to 2.6 percent in 2015 and 3.0 percent in 2016, only slightly up from 2.2 percent in 2014, according to the consensus.
That represents another big change from just six months ago, when analysts surveyed by ULI expected a 3.0 percent yield on Treasuries in 2015 and a 4.0 percent yield in 2016. Spreading worry over deflation in the world economy drove down the forecast. Some experts expect rates to stay low for even longer. “We think long-term rates are going to stay lower—closer to 2 percent for the next couple of years,” says Wang. “That is going to help real estate.”
Debt financing should be widely available. For example, investors are expected to buy up $115 billion in commercial mortgage–backed securities issued by finance firms in 2015, according to the consensus. That is up from $94 billion in 2014.
These commercial mortgages will also help borrowers refinance the $68 billion in commercial real estate loans made during the last real estate boom. Property values have largely recovered from the crash, so that most of these loans will be able to be refinanced, creating a significant opportunity for lenders. Billions of additional dollars in real estate loans will mature in 2016 and 2017, and some of these may be refinanced early, pushing lender activity even higher this year.
Underwriting for loans has begun to loosen as loan-to-value ratios increase and interest-only loans become more available. However, most real estate loans are still based on proven income produced by the properties—that is a big difference from the last real estate boom, when many permanent loans were made based on pro-forma income. “That’s a real positive. . . . You are sizing a loan based on what’s there today, rather than what is likely to come two years from now or not happen at all,” says Pendergast.
Real Estate Fundamentals Strengthen
The fundamental demand for commercial real estate continues to improve. Occupancy rates for office, industrial, and hotel properties will all surpass their 20-year averages in 2015. The percentage of vacant apartments will rise slightly to 4.7 percent—well below a 20-year average of 5.4 percent. Only retail properties, among the major property types, will continue to suffer occupancies weaker than the 20-year average for the property type, according to the consensus.
Overbuilding is not much of a threat to these strong fundamentals, though the apartment sector has seen some overbuilding in certain markets. “This cycle has seen far less new development than we have seen in past recoveries—and that is likely to continue, given the growing dour outlook globally,” says Pendergast.
However, demand for real estate in some secondary markets continues to lag behind core markets, the bustling areas where many young people are eager to live and employers are eager to rent office space. “Performance for secondary assets has barely improved from recessionary levels,” says Mulvee.
Demand is weaker in some suburban markets, and properties in trouble have fewer opportunities to reposition themselves. “In some of the stressed properties that secure CMBS deals, some of the toughest loss severities out there are in suburban office, where there is nowhere to go with a dark building and the severities are 85 to over 100 percent,” says Pendergast.
The U.S. economy is expected to strengthen, with economic growth of 3 percent in 2015 and 2016, according to the consensus. However, there is cause to worry that a weakening global economy will cause the United States to underperform. “My view has gotten more negative for the broader economy and the likelihood that we see a modest recession before we see a truly significant recovery,” says Pendergast.
Other experts worry that the Federal Reserve may raise its benchmark interest rates too quickly, choking off a strong recovery before it can really draw breath. “Past recessions have always started with the Fed tightening too fast,” says Wang.
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