Three Warning Signs For Commercial Real Estate And REITs

Forecasting the direction of real estate prices requires the same disciplined approach as for other goods and services. Here are three reasons why commercial real estate supply exceeds market demands, and the implications for your clients and their REIT investments.

Commercial real estate continues to be touted by analysts and media pundits as a sound investment. Since I have been one of the few consistent dissenters from this euphoric optimism, now is a good time to briefly review what I have been saying over the past few years.

In my article on commercial office markets published here three years ago, I pointed out that the red-hot sales of 2014 were very uneven. Nearly half of all investor money had poured into just five major metros – Manhattan, Boston, San Francisco, Los Angeles and Washington DC.

It was a very different story in most of the other major markets where weaknesses left over from the crash of 2008-2010 were still evident. Real estate data firm Cassidy Turley reported that 18 of the 79 major metros which they tracked showed higher vacancy rates in late 2014 than a year earlier.

Cassidy Turley also emphasized that the absorption of office space around the country since 2010 had been very narrowly focused. All the new space absorbed by tenants were in buildings either newly-built or newly renovated. Owners of traditional, older space, which comprised 60% of all office buildings in the nation, were still struggling to find tenants.

I warned investors not to be fooled by the strength shown in the hottest half dozen markets.

My follow-up article published in the summer of 2016 reported the cooling was showing up even in the hottest markets. Although total nationwide sales volume for 2015 had nearly reached the insane levels of 2007, this was due to continued enthusiasm shown by investors for those same six major metros. Manhattan alone accounted for 20% of all office sales.

By the middle of 2016, signs were beginning to appear that all was not well in the hottest markets. A construction boom throughout Greater San Francisco was throwing nearly 10 million square feet of new space onto the leasing market while the IPO market in Silicon Valley had slowed drastically. The soaring amount of sub-lease space thrown onto the market by firms that had leased too much during the boom years was another sign that the market was deteriorating.

Even Manhattan was weakening. Office sales volume was lower than a year earlier and available sub-lease space in the previously red-hot Midtown South was also rising rapidly.

While it was too soon in mid-2016 to say that office markets were topping out in the hottest major metros, I pointed out to readers that slowing sales volume was a clear warning signal for investors.

Here are three reasons why investors should be concerned about the commercial real estate market.

1. Declining sales volume

The most important indication that markets have peaked is a decline in sales volume. As 2017 unfolded, the weakening in sales became increasingly apparent. By November of last year, office sales nationwide were down 31% annually from November 2016 according to Real Capital Analytics.

The plunge in sales was most severe in what had been the hottest market in the nation – Manhattan. After peaking at $10 billion in the first quarter of 2015, sales had declined steadily and collapsed to under $1 billion in the third quarter of last year. The disappearance of Chinese money after the crackdown on foreign real estate investing by the Chinese government was clearly one of the major factors, but it was not the only one.

Sales in San Francisco – the second hottest market –collapsed in the fourth quarter of 2017. A mere two sales were closed in the entire quarter for a total of only 300,000 square feet. Take a look at this chart from Yardi Matrix:

Source: Yardi Matrix

For all of 2017, sales were down 58% from 2016. Chinese buyers – so important the past few years – simply did not show up.

At the time my first article was published in 2015, the third hottest markets were the Texas metros of Dallas and Houston. By the last quarter of 2017, both of them saw sales slow substantially – down 30% from the year-earlier fourth quarter according to Yardi Matrix's Texas report. For all of Texas, average price per square foot had plunged 36% from a year earlier.

The key takeaway from these sales figures is simple. Office investors are no longer willing to pay the sky-high asking prices of 2015. Because sellers have proven very reluctant to drop their asking prices, potential buyers walked away. One of the most important reasons for this is the more than 100 million square feet of new office space under construction now around the country.

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