COMMERCIAL REAL ESTATE TRENDS – JANUARY 17, 2007

In the last few weeks there have been several reports in professional publications describing  trends in commercial real estate capitalization rates and demand for different types of commercial real estate. 
 
During 2006 there were reports of some institutional buyers holding back on new purchases waiting for capitalization rates to move upward in response to rising mortgage rates.  These players appeared to be in the minority and the “cap rate compression� they were hoping would diminish continued to exist for most of 2006 as strong demand from many other buyers kept prices high for many categories of commercial real estate.  From recent surveys of potential buyers – principally institutions – it appears that there may be some upward pressure on capitalization rates as many buyers are becoming more selective in their investment standards.

It appears that retail real estate, which has been the most popular type of commercial real estate among real estate investors for the last several years, may have lost some of its appeal because, according to reports from institutional investors, retail properties have not performed as well as other property types.

Retail properties performed very well and better than other commercial property types from 2002 through 2004 but by 2005-6 their yields according to institutional investors had fallen behind the other property types.  Overall returns reported by institutional investors for the 2005-6 period showed retail property returns at about 16% while those for office properties were around 17%.  Furthermore the institutional investors seem to believe that some overbuilding coupled with declining consumer spending would make retail less attractive in future months than other property types.  The inventory of retail property for sale by late 2006 had risen substantially from 2005.

Investors now seem to be favoring apartments over retail properties based on their beliefs that apartments will experience significant rent increases in coming months since apartment rents rose very little across the U.S. since the turn of this century.  Many apartment investors appear to think that while capitalization rates for apartments will rise in the near term, the increased income from rising rents will more than offset the cap rate increases resulting in overall increases in values.  The strength of apartment investments is also bolstered by weaknesses in many single family and condominium markets around the country which is resulting in potential buyers staying in rental units until the single family markets improve.

For investors in smaller commercial properties (below $1,000,000) the effects of these trends will often be minimal since properties in this price range are not usually sought by institutional investors.  It is also the case that these national trends will not always manifest in all local markets.  The commercial property markets throughout the United States continue to be healthy and there are good returns available in many areas of the country and in all property types.