Investor Interest Pushing Prime Market Yields Down Significantly Edited by: Lisa Benston
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Source: Jones Lang LaSalle
Jones Lang LaSalle’s 2011 Spring Investor Outlook, which was recently released at the Urban Land Institute’s Spring Council Forum, points to a fast-moving capital markets return fueled by aggressive investor interest, additional capital availability and rental rate increases in numerous key markets. According to Jones Lang LaSalle the increased demand for high quality product is exceeding supply, pushing prime yields in several markets down to levels not seen since 2007.
Investor Outlook Highlights
New global forecast: Jones Lang LaSalle’s revised global transaction forecast calls for volume to be above $440 billion in 2011, up 35-40 percent from 2010 and the highest volume since 2007.
Increasing liquidity drives investment volumes: Americas direct commercial real estate investment totaled $31.3 billion in Q1 2011, which was more than double the $13.9 billion total in Q1 2010.
Debt deluge: CMBS is back with $9 billion in CMBS of issuance through April 2011 with at least $40 billion expected in 2011. Life companies also have returned as a major force in the market with originations by the top 30 life insurance companies up 39 percent in 2010 to $31.7 billion.
Rents rising: Twenty-one of the 44 markets Jones Lang LaSalle tracks posted asking rent growth quarter over quarter and the remaining 21 either saw rents flatten or decline quarter over quarter.
The capital markets recovery is being aided by an improving U.S. economic recovery. Employment appears to have entered a period of consistently stronger growth, manufacturing output is expanding robustly and business confidence is up. Corporate profits continue to be a core source of strength for the U.S. economy, and corporations are spending more on new technology and new hires, which should reinforce employment growth and bolster consumer confidence. Importantly, the credit markets are loosening and bank credit is increasingly available to small businesses. The U.S. Federal Reserve Bank has made it clear that while quantitative easing will end in June, interest rates will not rise soon.
“The economic fundamentals influencing the return to a robust trading market in commercial real estate are improving quickly, and that is going to push the level of asset trades to a new post-recession high, up near 60 percent in 2011,” said Jay Koster, President of Jones Lang LaSalle, Americas Capital Markets. “Given the improvements underway, we’re revising our 2011 global transaction volume forecast upward from an initial expectation of $380 billion to $440 billion this year.”
The level of investment sales in the United States continues to contribute strong gains to that transaction forecast as volumes totaled $23 billion in the first quarter 2011, doubling the level of a year ago.
“Demand for higher-quality product is now exceeding supply, pushing prime yields in several markets down to 2007 levels,” added Koster. “The volume of transactions ‘under contract’ continues to increase and reached a new high, for this recovery cycle, in April. That bodes well for a strong 2011.”
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Investor Appetite for Risk Increasing
Equity investors continue to target low-risk assets in prime locations, but are becoming increasingly frustrated by pricing and lack of suitable product. A number of investors are signaling a move up the risk curve, widening their geographical horizons and the types of assets they are prepared to consider. Interest is moving beyond the main gateway cities into markets such as Houston, Dallas, and Atlanta. The move into “riskier” transactions includes smaller assets, shorter income streams, lease-up risk, and development opportunities. However, most investors are still not prepared to compromise on quality and continue to show caution with regards to secondary assets. As investors move up the risk curve, their preference is for prime assets in “secondary” cities, rather than secondary assets in main cities.
Investor interest is rising in the market segments where rental spikes are occurring. Overall rent growth has been dominated by technology and energy-heavy markets, as well as the top four gateway markets of New York, Boston, Washington, DC, and San Francisco. In the tightest submarkets in those markets, like the Plaza District (New York), Back Bay (Boston), Rosslyn-Ballston and Capitol Hill (Washington, DC) and South of Market and CBD (San Francisco), rents have grown nearly 20 percent from cyclical lows over the past six months, yet have started to stabilize slightly in those four submarkets over the past several weeks after those severe spikes. In recent weeks, Silicon Valley, especially the Palo Alto, Mountain View and Sunnyvale submarkets, has seen rents increase drastically as demand for large blocks of space from technology companies has skyrocketed in the beginning of 2011. A total of 21 of the 44 markets Jones Lang LaSalle tracks posted asking rent growth quarter over quarter and the remaining 21 either saw rents flatten or decline quarter over quarter.
Capital Availability Improves
The U.S. debt markets have experienced significant easing with liquidity building and the return of the CMBS market. Through April 2011, $9 billion in CMBS was issued, far exceeding the nominal amount issued in the same period a year earlier, and already more than three-quarters of the total issuance recorded for the whole of 2010. Current estimates for 2011 issuance range between $40-60 billion.
“From nearly every capital segment there are more active participants, and the competitiveness among lenders has intensified markedly over the last few quarters,” said Tom Fish, Executive Managing Director and Co-Head of Jones Lang LaSalle’s Real Estate Investment Banking team. “The CMBS market has re-emerged and is once again considered a viable component of the market.”
Life companies have also led a lending resurgence to the commercial property market, ending a two-year slide. New originations by the 30 insurers with the largest mortgage portfolios soared by 39 percent in 2010, to $31.7 billion. Strong activity is expected for 2011, which follows declines of 41 percent and 35 percent the previous two years. This is positive news not only for acquisition growth but also for borrowers who need to refinance maturing loans.
Capital Markets Sector Outlook
Considerable momentum is building in the U.S. investment market, and the second quarter appears to be heading for a further increase in activity over first quarter 2011.
What’s Ultra Hot: Multifamily: The multifamily sector continues to witness very healthy investor demand as robust market fundamentals and the availability finance (including for new development) focus investor attention on this product type. In the U.S., multifamily sales represented 25 percent of all commercial property sales among the five major sectors. National vacancy rates have moved sharply downwards, declining by a further 40 basis points during Q1 2011 and are now approaching the six percent level. A combination of an improving labor market, the renewed fall in home prices and tight home-lending standards is increasing the propensity to rent, particularly among new-generation households. The U.S. home ownership rate has declined from a record 69 percent at the peak of the housing market to 66 percent in Q1 2011, and further modest declines through 2012 are possible. Occupancy rates and rents will also continue to be buoyed over the next year by low levels of new construction being delivered to the market. However, completions will begin to increase measurably in the latter half of 2012 and into early 2013, as active searching for construction financing for apartment communities – which is available in meaningful quantities – has surged over the last few months. A significant amount of groundbreakings is beginning in the second quarter and will be increasing in the second half of 2011.
Retail: Urbanization of U.S. retailing: A key issue facing the U.S. retail sector is the move towards urbanization that is pushing both consumers and retailers back to urban areas. Higher transportation costs, ‘baby boomer’ migration, and a growing preference for mixed-use, ‘walkable’ communities have led this change. There has also been a growing realization among a number of national retailers that many densely-populated urban markets remain significantly undersupplied, particularly when compared with much more saturated suburban and ex-urban trading areas. Many retailers – especially ‘big box’ – have already responded by opening scaled-down facilities in these areas in an attempt to boost sales. Looming issues, which could negatively impact retail, are the still-floundering housing market, sharply rising fuel prices and governmental budget cuts. In the Americas region, retail transactions totaled $5.5 billion and accounted for 18 percent of U.S. investment activity.
Industrial: Much of the recent spate of leasing activity in the U.S. industrial sector has centered on large corporate users, either expanding their supply chain networks (while costs are at historical lows) or via consolidations into higher-quality, prime locations that offer more functional warehouse or distribution space. Recovery in the industrial sector, which began on the coasts – led by the Inland Empire (in Southern California) in the west and Philadelphia/Central Pennsylvania in the east – is now extending to key inland distribution hubs such as Dallas, Indianapolis and Memphis. Average asking rents have been on a continual decline since early 2008. However, the rate of decrease has been slowing in recent quarters, and preliminary figures for Q1 2011 suggest that rents are beginning to stabilize. As demand fundamentals continue to firm and vacancy rates (which currently stand at approximately 10 percent) decline further, we expect an imminent bottom to ‘asking rents.’ However, rental spikes will be limited to those few markets, like the Inland Empire, where shortages of large blocks of available space are creating a supply vacuum. In general, rents are not anticipated to experience a significant uptick in 2011. Industrial transactions reached $7.5 billion in the first quarter, or 24 percent of all U.S. activity.
Healthcare: There is a great deal of pent-up demand for healthcare real estate, exemplified by more than $10 billion of capital raised in 2010 by healthcare-focused REITs due to the superior performance of medical office buildings and other outpatient facilities during the downturn. Supply of properties for sale is limited as healthcare systems shut down their new development over the last few years. Restoration of economic stability for hospitals, along with demographic growth and the push to outpatient services, is launching new development activity. Even though the tax-exempt bond market remains disrupted and expensive after it essentially disappeared in the fall of 2008, hospitals aren’t monetizing existing assets but instead are turning to third party developers for new capital. Cap rate compression for investor sales and deeper discounts for developer returns on new projects are de rigueur as investors compete for product.
Hotels: Hotel transaction volume in the Americas rose threefold and the region remains the most liquid globally. Activity was primarily driven by acquisitive REITs, which accounted for approximately two-thirds of transaction volumes. On the sell-side, investment funds, hotel operators and developer/property companies were most active.
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