Recovery in FIRE markets?

On a recent trip to New York, I had the opportunity to have a conversation with Deidre Bolton of Bloomberg Television about Colliers’ outlook on commercial real estate.

One of the major trends we touched on is the unevenness of the office market recovery. Colliers Research has observed for over a year that the strongest performers (in terms of job creation and office vacancy rates) have been what we call “ICEE” markets: those with an employment profile that strongly favors intellectual capital, energy and education, rather than markets traditionally associated with “FIRE” (financial, insurance and real estate) employment.

Recently, we've started to see the traditional FIRE markets catching up: FIRE absorption climbed to 73% of the ICEE total, up from 44% in 1H 2013; this counter-trend is supported in the October employment numbers.

But a closer look reveals an interesting fact: Most of the absorption in FIRE markets comes from submarkets with an ICEE profile. Submarkets such as West Los Angeles, New York – Midtown South, Chandler, AZ, and even Downtown Las Vegas are notable clusters of technology employment. Several Atlanta submarkets, allied with top universities and research institutions, are part of Atlanta’s transition from FIRE to ICEE.

The newly released North American Office Highlights report will takes a deeper dive into this topic, and includes a list of key submarkets to watch that are outperforming (or are poised to outperform) the metro areas in which they’re located.

What's driving cap rate compression?

After a recent client event in New York, I spent some time discussing the markets with KC Conway, chief economist in the U.S. for Colliers. It turns out we’re hearing the same question come up pretty frequently: What’s going on with cap rate compression? (KC has been having similar conversations regarding cap rates with bank regulators.)

Over the past 24 months, U.S. capitalization rates for all income-producing property types have declined to levels never seen before. Rate compression has been most pronounced in multifamily and credit-tenant, net-leased properties, where rates have dipped below 4.0%. Cap rate compression has been slower to occur in industrial real estate; however, that’s changing rapidly as investors rotate out of multifamily, and look to invest in the re-making of America’s supply-chain in response to growth in e-commerce and the Panama Canal expansion.

The Historical Perspective

As this graphic shows, we’re clearly in uncharted waters. The long-term average cap rate between 1965 and 2010 was 9.5%. After dropping to nearly 6.0% prior to the onset of the 2007-2009 financial crisis, cap rates rose sharply between 2008 and 2010 to 8.5%. This increase, around 200 basis points, eliminated approximately 25 percent of commercial real estate values. During the recession, increasing vacancy rates and declining rents caused another 20 percent decline in values, as indicated by the Moody’s Commercial Property Price Index (CPPI).

Source: American Council of Life Insurers.

All told, roughly 45 percent of the value of commercial real estate was wiped out from 2008 to 2010. But less than three years after the “Great Recession,” commercial real estate values have rebounded. Institutional capital and commercial real estate investors are pursuing income-producing real estate again, and have bid average cap rates to a new historic low: under 6%. Why; and what is behind this trend?

Many ascribe the trend to institutional investors’ ongoing search for yield, but of equal import is investor anxiety over Federal Reserve monetary policy aimed at devaluing the U.S. dollar and re-inflating asset prices out of the risk curve. With a 10-Year Treasury yield around 1.8% and inflation near 2%, commercial real estate certainly seems more attractive--even at a historically low 4% to 5% cap rate.

What about equities or stocks? Here commercial real estate is increasingly attractive because of its relative stability. With most major U.S. stock indices at near-record highs, and the volatility in electronic trading that can move equity prices by as much as 5% in a single day, commercial real estate is a consistent way to attain cash-on-cash yield above 4% (and as high as 7% or 7.5% in secondary markets) without the daily fluctuation in asset price.

But there could be more to this trend than just a search for yield. The approaching retirement of millions of baby-boomers may see investor goals shift toward cash flow and dividends, and away from long-term asset appreciation. Certainly low interest rates have also been a factor. Would multifamily cap rates be in the 4-5% range without cheap Freddie Mac and Fannie Mae debt? 

The question is whether cap rates must necessarily spike as interest rates rise. With so much capital on the sidelines waiting to be invested, could the conventional wisdom of overleveraging--because equity is expensive and debt is cheap--be turned upside down in the next five years?