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Soaring commercial real estate market is now bigger than it was in 2006

Lawrence Lewitinn
Lawrence Lewitinn

Commercial real estate has been booming this year, with some surprising markets outside of New York or San Francisco making incredible strides. But there are signs the phenomenal run in income-generating properties may be decelerating.

For the first half of 2015, volume in U.S. commercial real estate – properties like office buildings, shopping malls, and apartment complexes priced above $2.5 million – grew 36% compared to the same time last year, according to data compiled by Real Capital Analytics. At $255.1 billion, transactions were just ahead of the pace set in 2006.

A total of 15,610 of such commercial properties changed hands with an average transaction price of $16.3 million. That's a huge increase in both quantity and price from the first half of 2014 when 13,270 properties averaged $13.9 million.

Location, location, location 

The six markets with the largest volume were responsible for 31% of commercial deals. New York, Los Angeles, Chicago, Dallas, Atlanta, and San Francisco had a combined total of $79.4 billion in commercial property transactions in the first half of this year, 42% higher than what they saw the same time in 2014.

Some smaller markets saw much larger percentage upticks. Orlando’s $4 billion of transactions from January to June 2015 was more than three times the previous year. Places like San Antonio, St. Louis, Raleigh/Durham, and Palm Beach doubled their deals amounts from last year.

“We’re starting to see capital move into some of these secondary cities in ways that they’ve been doing traditionally with the primary markets of the U.S.,” said Jim Costello, senior vice president at Real Capital Analytics, adding that Houston’s $6.3 billion in “deal volume has been increasing at such a pace that it’s helping to bring prices up to levels higher than seen before the financial crisis.”

However, Costello doesn’t see a complete comparison in the overall commercial market to the last boom cycle.

“I don’t think we’re headed into another meltdown,” he said. “There are some similarities in high-level numbers, but the things that are taking us there are different.”

A "more cautious" boom

Unlike a decade ago when speculators would borrow the full cost of a property – and then some – in hopes the rising market would outpace costs, buyers are now more conservative, according to Costello. For example, investors put more of their own money up front relative to what they borrow.

“At the previous peak, the expectations investors had were a lot different,” he said. “Deals that are being done today are being done with a lot more caution.”

And the pace of the frenzy appears to be subsiding a little. While commercial real estate is in the midst of a growth spurt in 2015, the rate of that growth slowed from the first quarter to the second. Q1 saw an astounding 49% year-over-year increase in volume while Q2’s year-over-year growth was 23%.

Costello finds no reason to be concerned about the recent change in growth rates. “Some people start to look at that slowing and start to worry that investors are getting cautious,” he said. “But I look at it in a positive sense. If we had continued at some of the 30% to 50% year-over-year growth patterns we saw in Q1, maybe then you can probably talk about a frenzy and even the dreaded ‘bubble’ word for commercial real estate.”

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The search for yield

Properties that saw the most year-over-year volume growth in the second-quarter were industrial (40%) and suburban offices (37%). Those sectors showed a cap rate – a property’s net operating income relative to value – of around 7%. The weakest volume growth was in apartment complexes, which saw just 13% increases. Apartments had a lower average cap rate of 6%.

Like the relationship between bond prices and yields, property prices are inversely related to cap rates. Thus apartment complexes were at a higher valuation relative to higher-growth sectors like industrial and suburban offices.

“The price-per-unit of apartment complexes… is at a record-high level,” Costello said. “Investors are looking at that and thinking about other commercial real estate investment classes. They see some good yield opportunities in things like suburban office, industrial properties – properties that haven’t seen as strong of a price recovery yet.”

“They look at this as maybe an opportunity to move into something with some additional gains in the years ahead,” he added.

 

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