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Commercial Real Estate Still Encounters Headwinds
Commercial real estate (CRE) markets have been under pressure since late 2007. Within the last 18 months, the spread between cap rates and 10-year U.S. Treasuries—reflecting the risk premium associated with investing in CRE and indicating a potential "flight to safety" as the risk premium that investors require—appears to be increasing between the property segments associated with lesser risks (multifamily/office-Central Business District) and the greater risk segments (strip center, industrial, and office-suburban [see chart 1]).
The National Council for Real Estate Investment Fiduciaries' property index showcases the rates of return for a large pool of individual private market commercial properties. Following stresses in the CRE market, rates of return improved steadily in 2009–10; however, in 2011 downward pressures have reemerged (see chart 2).
The bottom line is that commercial real estate (CRE) markets continue to give off conflicting signs. High unemployment and sparse job creation are delaying the recovery of several segments within the CRE market. The exception is the multifamily segment, which has benefited from increased renter and investor demand (see chart 3). However, recent data indicate a possible slowing in multifamily. A lack of consumer confidence, income growth, and employment continues to hamper the recovery of the office and warehouse markets. Many analysts expect the retail market to continue to decline in the short run before stabilizing (see chart 4). Hotel properties rebounded nicely, many with double-digit gains off the 2010 lows. The commercial mortgage-backed securities (CMBS) market continues to work on overcoming recent setbacks associated with its ratings issues and the tightening of the market.
Multifamily. While the pace of improvement moderated relative to the first quarter, the multifamily segment remained the best-performing CRE property type. Landlords continue to see healthy gains in effective rental growth rates that have risen for five consecutive quarters. This improvement followed nearly a year and a half of declines. On a year-over-year basis, rents are up 6 percent while vacancy rates fell to their lowest levels since mid-2007. Industrywide vacancy rates have decreased for six consecutive quarters, and absorption continues to outpace new units delivered to the market. This rebound has been aided by turmoil in the single-family home market (see chart 5).
Office. Vacancy rates have decreased for the last four quarters. The decreases have been small (less than 20 basis points), however, as underlying job growth, economic factors, and property fundamentals remain weak. Market performance is still highly influenced by geography and product type. Finance, insurance and banking have been key drivers of market absorption. There has been job growth in other key industries that use office space, but the recent resurgence in these markets is still in the early stages (see chart 6).
The volume of office sales among the top ten markets with the lowest vacancy rates has rebounded. Investors are looking for quality assets, and significant competition has emerged for well-located trophy properties. Recent market information indicates that trophy properties appear to be fully priced. In the Sixth District, Miami and Orlando were ranked number 9 and number 11, respectively, on the list of markets with lowest vacancies. Atlanta, Miami, and Palm Beach were among the markets with the highest office sales volume (see the table).
Warehouses. Warehouse CRE continued to stabilize with a 20 basis point decrease in the overall vacancy rate. Performance varied widely based on geography. The recovery of the warehouse market is highly dependent upon shipping, manufacturing, and job creation. As each of these categories remains flat, recovery will most likely be modest in the short run. Almost half of the major markets tracked by the Atlanta Fed showed an increase in vacancy rates. Negative net absorption reached record levels in Nashville. Atlanta's vacancy rate also increased (see chart 7).
Retail. Retail market fundamentals continue to deteriorate. Vacancy rates have been climbing since mid-2006, and rents have generally declined since mid-2008, though the rate of decline for both vacancy rates and rents has slowed in recent quarters. The most recent data indicate the retail market experienced falling rents while vacancy rates increased slightly, by 10 basis points. Personal bankruptcies and a lack of consumer confidence and spending continue to weigh on the sector. Several analysts expect the retail market to stabilize sometime next year. Sixth District markets saw mixed results. Tampa and Jacksonville saw minor decreases in vacancy, while Orlando saw a small increase. Atlanta and Miami experienced larger vacancy increases (see chart 8).
Hotels. The hotel segment improved during the second quarter of 2011 with strong gains in all three key metrics (occupancy, average daily rate (ADR), and revenue per available room). The gains included both the full-service and limited-service product types. Locations in the Sixth District rebounded from the lows of the second quarter of 2010. Miami, West Palm Beach, Fort Lauderdale, Nashville, and Orlando experienced significant increases in both ADR and occupancy. Atlanta and Tampa had positive, though smaller, gains (see chart 9).
CMBS. Delinquency rates for CMBS continued to climb in 2011; however, the rate of deterioration has been moderated by a spike in the increased amount of troubled debt resolutions. The CMBS delinquency rates merit close surveillance in the near future as the volume of maturing loans increases (see chart 10).
Headwinds continue to persist in CRE. However, performance varies by sector and class, and some markets are experiencing more improvement than others. A broad-based recovery in CRE is highly dependent upon improvement in labor market conditions.
This article was written by Brian D. Bailey, a financial policy analyst in the Atlanta Fed's Supervision and Regulation Division.