CRE Deal Volume at All-Time High. But What Lies Ahead?

By Rick Sharga, Executive Vice President, Auction.com: Find out Rick's take on what's in store for the CRE market and why.

By Rick Sharga, Executive Vice President, Auction.com

Rick Sharga

Just in case you missed the news, the commercial real estate market is in full recovery.

As we noted in our Q1 Auction.com CRE Market Monitor, CRE deal volume in the first quarter hit an all-time peak of $124.3 billion, a 47.4 percent increase from the first quarter of 2013, and a 0.1 percent increase from the fourth quarter. Even that seemingly miniscule gain is noteworthy: typically there’s a rush of fourth-quarter activity in the CRE market, and an inevitable pull-back in the first quarter. We haven’t seen a Q4 to Q1 increase since 2007, which is more or less the last time the market was on fire.

This has led some folks to question whether we’re about to run into problems. After all, the last time we saw prices soar and sales volume increase like this was just before the meltdown. But while anything is possible, it certainly doesn’t feel like we’re heading into another market crash.

There are some signs that the market may be over-heated. Cap rates, for instance, are below their 10-year averages in all five market sectors – with the Office, Apartment and Retail sectors all at 10-year lows. And risk premiums (a metric that Auction.com Research uses to measure how much risk investors take on relative to the 10-year U.S. Treasury rate) rose between 28-38 basis points across all sectors on a year-over-year basis. This all suggests that investors are paying higher prices for CRE assets than the underlying fundamentals might support.

But there are also some powerful forces at play that suggest that the surge in CRE activity still has plenty of momentum behind it.

For starters, there’s still an enormous amount of capital available to be deployed, and many investors would rather put that capital into commercial properties than other investment options, which are either far more volatile or offer far less exciting returns.

Foreign investors, who poured some $48 billion into the U.S. CRE market in 2014, continue to view American commercial assets as much safer options than what’s available in their own countries. There’s faith in the U.S. government to honor real estate contracts and faith in the U.S. economy to be more stable than the rest of the world, even in its currently moribund state. Somewhat surprisingly, investors from Asia, particularly China, find U.S. CRE properties to also be a relative bargain. While American investors are dissuaded by high property prices in New York City, San Francisco and Los Angeles, Asian investors used to much higher prices in markets like Singapore and Hong Kong are more than willing to gobble up these assets. Even the strength of the U.S. dollar hasn’t proven to be an impediment (at least not so far) to offshore investment, although there appears to be a bit of a shift to lower priced secondary and tertiary markets, and to less expensive sectors like retail and multi-family, perhaps to offset the less favorable exchange rate.

Interestingly, one of the biggest reasons for optimism is that all five sectors appear to be the beneficiaries of strong and/or improving market fundamentals. The office sector is being bolstered by a steady increase in the number of jobs created and lower unemployment rates. A strong tourism industry, along with healthy business travel is bolstering the hotel sector. The multi-family market is in almost uncharted territory, with 97 percent occupancy rates across the country, and household formation numbers suggesting a potential shortage in the supply of rental units. Retail sales have shown strength in recent months. And the industrial sector saw nearly double the number of transactions in the first quarter compared to a year ago.

All of these factors – the availability of capital, the low interest rate environment, the infusion of foreign capital, and the continuing recovery of the U.S. economy – point toward even more growth, and a robust CRE market for the rest of 2015.