Fundamentals Rule the Day for Investors

Why investors are going back to the basics in order to find and assess the best commercial real estate values, according to Situs RERC President Ken Riggs.

Ken-Riggs_webThe market knew that the era of cap rate compression would come to an end—and the time has now arrived. The era of double-digit returns generated by appreciation-driven values over this cycle is over as well. The CRE market is experiencing headwinds that have slowed transaction volumes and placed downward pressure on prices and values. With the Fed’s December rate hike, those headwinds are likely to become stronger. Returns will once again rely more heavily on the income component and less on appreciation, with market fundamentals the essential drivers.

This trend can be seen in the apartment sector. Based on a number of factors, Situs RERC’s top three ranked major metros in the apartment sector are Dallas, Atlanta and Seattle. These markets have many common strengths that will help withstand the headwinds and drive their rankings, including strong population growth and households growing at nearly twice the rate of the nation. Each is also relatively young and forecast to have more 25- to 34-year-olds—the prime renting age for apartments—than any other age group, which bodes well for income growth. Each has increased its economic diversity across employment sectors, especially in tech and health care. This attracts young, highly educated and highly paid workers, who usually seek urban living as opposed to buying homes in the suburbs, triggering higher rents in CBD locations. Considering these metros’ sturdy wage growth and affordability, there is still room for the income component of returns to grow. Additionally, these metros rank high in apartment deal transaction volume, adding liquidity for investors.

Challenged markets

situs RERC Apartment - Major Markets
Source: Situs RERC

Our market forecast also examined the major markets with the greatest challenges regarding value versus price for the apartment sector: Los Angeles, Washington, D.C. and Manhattan. Though larger in size, our metro investment ranking model placed these markets lower in the major market classification due to various economic and commercial real estate fundamentals. In contrast to the top of our list, these markets are experiencing weaker population and household growth, high cost of living, and tepid employment and wage growth. They are also hurt by the levels of new supply forecast to come online, which will soften occupancy and dampen income expectations. While these markets are seen as the traditional gateway markets, particularly by foreign investors, the influx of capital and investor interest has driven prices to levels that are no longer attractive relative to valuations. Although the new supply could begin to cause upward pressure on cap rates, deals remain overpriced to relative value, causing a lack of urgency among buyers as they see developers lowering costs and offering increased incentives.

The apartment rankings for the major metros show that with cap rates flattening or possibly reversing course, and interest rates rising, fundamentals are again becoming the key in assessing CRE value. In the short term, we do not expect interest rate hikes alone to have a large, harmful effect on real estate. Assuming they continue to be small, incremental, clearly communicated in advance, are justified by economic growth and are baked into the market calculus for CRE pricing, the markets will not overreact. CRE is a long-term investment strategy; as long as the cost of money remains far below historical levels, the rate hikes are unlikely to shake investors. All the same, investors would be wise to refocus on fundamentals as their road map to finding the best value.