ViewPoint: Commercial Real Estate Spotlight: 2010 Q2
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Although varying widely across individual markets, overall commercial real estate (CRE) conditions displayed some signs of stabilization in the second quarter of 2010 as the pace of increase in vacancy rates slowed. On a quarterly basis, vacancies rose 10 basis points or less in the office, retail, and warehouse sectors (see chart 1).
However, the August 2010 Federal Open Market Committee (FOMC) statement noted that "the pace of recovery in output and employment has slowed in recent months." Therefore, it continued, a sustained recovery in CRE will remain contingent upon more robust trends in employment and income growth and any subsequent improvement in consumer spending and business investment.
The multifamily sector remained a comparative bright spot in the CRE market, with vacancy rates retreating to just 7 percent in June—their lowest level since early 2008. Although benefiting from tepid home sales, falling homeownership rates, and access to capital by virtue of stresses at Fannie Mae and Freddie Mac, this property type will continue to face competition from distressed single-family homes and condos that are being turned into rental properties. Nevertheless, investors are likely to be willing to accept any losses in the near term (net operating income for multifamily real estate investment trusts (REIT) continues to trend downward) in anticipation of a return to effective rent increases first occuring in this sector.
Hotel operations gained with modest improvements in tourism levels while business travel bottomed out and is expected to increase only slightly this year, according to an Aug. 11, 2010, report from the National Business Travel Association. Reflecting somewhat firming conditions, revenue per available room (RevPAR) in the second quarter of 2010 increased 8 percent from a year earlier. Nonetheless, at $75.21, RevPAR is still well below peak levels.
Stabilization in CRE has coincided with a slight rebound in property prices. After bottoming out last October, Moody's Investor Service's commercial property index has cautiously edged upward; however, prices remain 39 percent below their peak. Guarded yet growing confidence in CRE prospects and possibly limited alternative investment opportunities may be reflected in the decline in cap rates during the second quarter. An interpretation of cap rate data, especially at the local level, must be tempered by still comparatively low transaction levels and investor interest focused on only the best properties.
CRE remains a distressed asset, especially for business/commercial (B/C) class properties. Commercial mortgage-backed securities (CMBS) delinquencies (those more than 60 days past due or in foreclosure) continued to spiral through June, particularly for multifamily and hotel property types. Moreover, because of continuing sharp increases in the number of loans transferred to special servicing, asset quality will remain an issue.New Supply
Overall, moderating CRE construction activity is helping to constrain greater increases in vacancy rates. Dwindling space in the pipeline suggests that 2010 completions will fall well below last year's levels. Although showing the least decline, the multifamily category may be best positioned to absorb new space given the already falling vacancy rates. While helping to contribute to market stabilization, a shrinking pipeline will not necessarily help the economy recover as nonresidential construction job growth remains negative (see chart 2).
Evidence of a recovery in multifamily housing is underscored both by six consecutive months of effective rent growth through June 2010 and by declining rent concessions. Moreover, all of the largest markets saw gains in effective rents. Despite these increases, it appears that Houston faces more heightened risk as job growth remains negative, occupancies are below 90 percent, and more than 2,700 units are in the pipeline. Some other markets, notably Tucson, Las Vegas, and areas in Southern California, also continue to struggle (see chart 3).
Although preliminary data for July 2010 indicate a return to positive territory for the first time since early 2008, office employment is still down over 2.3 million from its peak. Lack of a more robust rebound in this critical demand driver is evidenced by continued increases in vacancy rates, which rose in 90 percent of markets. Detroit remained the worst-performing market, followed by Riverside, Calif., and Phoenix. Any improvement in vacancy rates was isolated to smaller markets (see chart 4).
Lackluster labor markets and income growth, a weak recovery in retail sales, persistent store closings, and further increases in business bankruptcy filings continue to weigh heavily on retail market fundamentals. Nearly 40 percent of properties have declining asking rents. Vacancy rate increases, led by Baton Rouge and Mobile, have occurred in the majority of markets. On the other hand, one of the few positives for this sector has been the sharp reduction in construction activity, which has helped to mitigate the rise in vacancy rates (see chart 5).
Weak retail sales continue to constrain demand for space in the warehouse sector. In the second quarter of 2010 nearly all of the largest markets saw increases in vacancy rates (see chart 6).
The hotel sector saw widespread improvement in the second quarter with RevPAR rising in most major markets from a year earlier. Increases in RevPAR were led by New York and New Orleans, which saw gains of just over 20 percent. It should be noted, however, that these gains were off of very low levels. However, a few markets, such as Orlando and Houston, continued to struggle, with room revenues slipping slightly (see chart 7).
CRE Capital Markets
While still nearly 40 percent below peak, property values bottomed out in late 2009 and have since slowly drifted upward (see chart 8). Similarly, CRE rates of return rose across all property types in the second quarter (see chart 9).
Investment activity has increased as well, primarily for well-placed Class A properties. Investment sales volume rose 67 percent to $36.2 billion, while CMBS issuance stood at $2.4 billion during the first half of 2010. Though improved from 2009, market activity remains well below peak levels.
CMBS delinquencies posted new highs in the second quarter, painting a bleak portrait of market conditions for B/C class properties, particularly in states such as California and New York (see chart 10 and the table).