Commercial Real Estate on the Mend

CoStar, observers see two-tiered recovery

July 15, 2011

Commercial real estate markets show signs of improvement from the price trough of 2009, but the recovery is mixed, with apartments, fully-tenanted properties, and properties in the strongest metropolitan areas making the best showing. Other properties, however, continue to lag.

CoStar reports a 150% increase in the volume of commercial property sales from May, 2010 to May, 2011. An increase in sales volume typically precedes an increase in prices. The run-up in prices was less for investment-grade properties than for general commercial properties in the period from 1998 to 2007, according to CoStar, which publishes various indices of price trends, based on same-property repeat sales across the U.S. The price decline from the peak (identified by CoStar as August of 2007), however, was roughly the same for investment-grade and general commercial properties.

Moody's Investor Service identifies October of 2007 as the commercial real estate price peak. Moody's reports a price increase of 26.7% for non-distressed, high-quality properties from December of 2009 to March of 2011. The data from Moody's are consistent with indexes published by SecondStreetIndex.com, which show a recovery of much of the value lost in late 2008, but only in strong sectors. The strongest sector, apartments, has shown the strongest recovery. The office and industrial sectors, however, have continued to lag.

CoStar reports a price decline of 34.4% since August of 2007 for all commercial real estate in its Composite Commercial Repeat Sales Index. The one-year trend shows a continuing, but smaller, decline of 6.8%. In spite of the upward pull of recovering high-end properties, the drag from properties in the lower tiers has produced a one-year general downward trend.

Moody's shows an even larger downward trend since the peak of the market. Moody's comprehensive price index for all commercial properties shows a decline of 47% since October of 2007.

"It's a world of two classes," says Greg Merage, as reported in the National Real Estate Investor this month (July, 2011). Robert Bach of Grubb & Ellis observes that, because prices have been driven up so strongly for high-quality properties, investors have become less wary about second-tier investments and are now more willing to consider investments in properties that may not be fully tenanted, that are in the weaker office and industrial sectors, and that are in weaker metropolitan areas.

He sees three reasons: intense competition for prime properties, continued low interest rates, and improvement in the availability of capital. Like other observers, Bach notes "the trend . . . for banks to be more willing to make loans."

The sales volume increase reported by CoStar is a strong indicator of price recovery across all commercial real estate sectors. Commercial price trends generally follow trends in the larger economy. Gradual growth in the U.S. economy, though slow, will result in job and income growth. Hessan Nadji of Marcus & Millichap forecasts "a gradual drop in vacancy rates across all property types."

If past trends are a guide, whether second-tier properties join and, potentially, surpass prime properties in terms of price increases will depend on the duration and strength of the present economic recovery.

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