2014 Midyear Market Review provided by the CCIM Institute

2014 Midyear Market Review
We’re only halfway up the mountain.
by Anthony M. Graziano, MAI, CRE, FRICS, and Matthew S. Krauser, CRE, FRICS
In January, Integra Realty Resources released Viewpoint 2014, reflecting our national assessment of real estate market cycles throughout 63 primary, secondary, and tertiary U.S. markets. These preliminary results of our midyear update highlight forecasts for markets with solid investment fundamentals for the balance of 2014.

Key Trends
Prior to assessing the midyear market, first consider some key trends that affect the national commercial investment market.

Changes to the financial services industry will reduce near-term commercial leverage. The U.S. real estate markets are tightly coupled with one another due to underlying structural changes in banking and finance. It began with the forced bank consolidation during the savings and loan bailouts of the 1990s and has now reached a critical mass with “too big to fail” institutions resulting from the massive federal bailout of the U.S. banking system in 2008 and 2009. According to the most recent FDIC report, 21 banks out of the total 6,812 U.S. banking institutions hold $7.8 trillion in assets of the total $12.7 trillion asset base. In other words, a mere 0.3 percent of the banks manage 61.7 percent of the assets. Another 86 banks hold an additional 18 percent of assets and make up only 1.2 percent of the total institutions. Thus, 80 percent of the total U.S. asset base is held by fewer than 107 banks out of 6,812 total institutions. The balance of the banks have assets of less than $10 billion and represent about 20 percent of the total asset base.

Due to regulatory changes, small and midsize institutions remain under extreme cost pressure to consolidate. While the number of institutions continues to decline quarterly, FDIC analytics indicate continued strengthening of bank balance sheets. The number of banks will decrease for the balance of 2014 primarily due to consolidation, not bank failure, because core asset values (residential and commercial investment real estate) continue to improve.

Our survey of IRR offices indicate that the close of first quarter 2014 demonstrated much weaker lending pipelines and increased competition by banks for viable commercial deals. The bulk of the refinancing activity from 2012 and early 2013, which fueled the banking recovery, now appears to be slowing. This will likely have negative implications for lending volumes (and hence bank profitability) for the balance of 2014.

Some of this is a healthy correction as asset values have recovered from the recessionary trough in all U.S. markets. The reality is that we’ve climbed the mountain and have celebrated our ascent from the bottom, only to realize the climb is only half over. Now we must keep from falling off the path to the top of the mountain.

Global cash seeks security in U.S.-based assets. All of the IRR offices in major markets (populations greater than 3 million) report an increasing presence of foreign investment capital. Major cities such as San Francisco, Los Angeles, Boston, Philadelphia, Miami, Atlanta, New York, Washington, D.C., as well as Houston, Dallas-Fort Worth, Chicago, and Salt Lake City are experiencing a significant influx of direct foreign investment from China, Europe, and South America. Trophy properties in almost all major American cities are being competitively bid up with strong doses of foreign capital seeking refuge from emerging market volatility. This leads to large portfolio transactions reaching the investment thresholds of sovereign wealth funds and major institutional pools.

There is no formal tracking mechanism for true foreign investment totals. Private equity funds can be U.S.-based but internationally backed. The public real estate investment trust market is agnostic as to where its investment capital originates. While the lack of formal foreign tracking makes true foreign inflows less transparent, IRR believes the amount of capital originating from outside the U.S. is buoying the market.

Private and REIT capital will favor the major markets to the exclusion of tertiary metros. This competition for major assets and portfolios will fuel investment migration toward secondary metros with strong fundamentals, such as Denver; Phoenix; San Antonio; Detroit; Charlotte, N.C.; Atlanta; Tampa, Fla.; Indianapolis; and Seattle.

Baby boomer retirement is knocking. IRR’s senior and healthcare specialty practice group reports continued strong transaction activity and demand throughout the U.S. Some of these fundamental improvements reflect a maturing industry model and increased operating capabilities of the large platform operators. But this market is affected by a core demographic shift for which this industry has been waiting and planning for more than a decade. This asset class continues to grow across all U.S. markets.

Tertiary market investment in new development is a strong value play with fewer competitors in addition to equally strong fundamentals, since boomers older than 70 years will tend to migrate back to where their children live. The key metric here is markets with high-wealth, high-value employment, since working children often provide funding for extended healthcare, assisted living facilities, and continuing care retirement communities.

But the extended life expectancy of the baby boomer generation favors Sun Belt markets in 2014–15, never more so than following the brutal winter of 2013–14. The Carolinas, Savannah and southern Georgia, Florida, Southern California, Arizona, South Texas, and now Tennessee will be strong in-migration markets, with fundamental improvements in second-home residential housing, and by extension, retail investment to serve the growing population base. Continued improvements in core housing values will favor migrating boomers with proper equity leverage, facilitating relocation to warmer climates before the winter of 2014–15.

The Big Picture
Asset pricing peak to trough is well over, and many markets report a return toward prior peaks. Some of this asset appreciation is being driven by too much cheap capital chasing real estate deals, but it is mostly big capital such as REITs, private equity, and pension and sovereign wealth funds. Opportunities still abound in the tertiary markets where the long tail of recovery will favor under-the-radar investing.

The coastal cities emerged from recession quickly, and the major U.S. markets were aided by foreign and domestic investment capital that did little to assist inland tertiary economies. Texas, Oklahoma, the Dakotas, western New York, eastern Ohio, and Pennsylvania are the oil and gas extraction/production engine of the U.S. Extraction and speculation pushed their local economies through recession more quickly. Most if not all of the major coastal and energy-producing regions are getting expensive again because observers can see a clear path to wage, employment, and housing growth.

However, the balance of 2014 and early 2015 will be punctuated by new start-ups and internal business growth as entrepreneurs and small businesses catch up. This favors the inland tertiary markets.

The 2014 deal flow will very likely continue an average upward trajectory, but pricing will be more volatile. Major portfolio transactions and triple net lease transactions will accelerate as investors will demand security and diversity in exchange for higher asset pricing. The tertiary capitalization rates have been compressed due to financing availability, but we expect to see strong transaction activity at the local level in tertiary markets as local investment boomers cash out in 2014–15.

Investment Opportunities
Real estate value — and value growth — is a residual product of the local economy. As economic activity expands, so will real estate values. Here are key trends and markets to watch by property type.
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