March 17, 2016
The commercial real estate sector faces its strongest headwinds in four years, owing largely to an abundance of supply that could weigh on valuation and spreads. Improving fundamentals—rent rolls, vacancies, and cap rates—have largely offset supply concerns, but we remain cautious. Vacancy rates in multifamily properties declined to 7 percent as of Q3 2015, almost half of 2009’s 13 percent rate. Similarly, office vacancy rates in suburban and downtown markets have declined to 16 percent and 12 percent, respectively, down from 20 percent and 15 percent during the crisis. These declines in vacancy rates have led to increased rents for apartments and office buildings; over the last two years, apartment rents have risen at an average annual rate of 4.7 percent. As vacancies decline and rents rise, office and apartment construction is increasing, especially in urban areas. Apartment construction, which is at the highest level of the last 30 years, is expected to peak in 2016.
Commercial real estate loans have not been immune to the spread volatility that corporate bonds have experienced over the past several months. Since December 2014, asking spreads have widened by approximately 29 basis points across property types, on average.
Source: Trepp. Reflects 10-year loans with 50-59 percent loan to value as compiled by Trepp. Data as of 12.31.2015.
Commercial real estate property prices rose by 13.3 percent in 2015, according to the National Council of Real Estate Investment Fiduciaries, led by 15 percent total return in retail properties. Market participants expect another 11–12 percent rise in commercial real estate in 2016, but we believe easing investor demand for real estate debt will lead to slower growth; we have already experienced a correction and are trading at significantly higher spreads and yields. Since December 2014, asking spreads have widened by approximately 29 basis points across property types, on average (see chart, top right).
We expect sustained investor demand for U.S. real estate from offshore investors to continue in 2016. Cross-border demand for commercial real estate ticked up in 2015 to 19 percent of total demand as foreign investors sought safe haven in U.S. assets (see chart, bottom right). This demand should provide some stability to property prices in both core and second-tier markets in the coming year, nevertheless we will be focused on whether increased construction activity will tip the supplydemand balance.
Cross-border demand for commercial real estate ticked up in 2015 to 19 percent of total demand as foreign investors sought a safe haven in U.S. assets. We expect foreign demand will remain strong in 2016, but demand from other investors may decline as investors seek opportunities in asset classes that currently feature more attractive valuations.
Source: Real Capital Analytics, Morgan Stanley Research. Data as of 12.15.2015. Numbers may not sum to 100 due to rounding.
—William Bennett, Managing Director; David Cacciapaglia, Director
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Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment-grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating-rate senior-secured syndicated bank loans and other floating-rate securities involve special types of risks, including credit risk, interest-rate risk, liquidity risk and prepayment risk.
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