In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss current trends in commercial real estate transaction levels and whether they may have bottomed with Senior Commercial Real Estate Economist Xander Snyder.
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Listen to the REconomy Podcast™ Episode 89:
“Well, I think the silver lining is that these levels were very likely at or near a trough in transaction volume. Now, that said, transaction volume could easily remain muted over the next several quarters, especially if inflation re-accelerates and interest rates remain 'higher for longer.' At a certain point though, the wall of mortgage maturities that we've talked about on other episodes will remove this wait-and-see option for a lot of sellers. And when there are forced sales that gap in price expectations will narrow further.” – Xander Snyder, senior commercial real estate economist at First American
Transcript:
Odeta Kushi - Hello and welcome to episode 89 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American, and Xander Snyder, senior commercial economist. Hey Xander.
Mark Fleming - Hey Odeta and Xander. The trio is back. And I'm not sure if folks noticed the title of the podcast. But does, how low can you go, or can it go, mean we'll be doing the limbo as we record this episode?
Odeta Kushi - Maybe that's what we need more of in real estate -- tests of physical flexibility.
Xander Snyder - If you can Limbo under a certain height, maybe you can get a few basis points knocked off your mortgage rate.
Mark Fleming - Limbo-based financing. Now we're getting creative with our deal structures. Although, last time we got creative with our financing some things not so good happened.
Odeta Kushi - Let's not go there. Now, as much fun as the limbo would be, the metaphor we're going for today is about commercial transaction volume. Transaction volume is a measure of how many commercial real estate transactions were completed in a given period. And in the first quarter of this year, that figure was low, low low.
Xander Snyder - I simply can't resist, but is that a Flor Rida reference, Odeta? Low, low, low. Okay, better stop there.
Odeta Kushi - Oh, goodness, lo and behold, I can reference my era of music.
Xander Snyder - All right, so turning back to business? Yes, there just aren't a lot of commercial properties trading right now,
Odeta Kushi - You can say that again.
Xander Snyder - There just aren't a lot of commercial properties trading right now.
Odeta Kushi - Very funny. I thought you said we're back to business.
Xander Snyder - Yeah, there, there are all sorts of ways to measure transaction volume. And the most common is the total amount of dollars transacted in a certain time period. And this is a useful data point, because it gives you a sense of how much capital is flowing back and forth over time. But, typically, transaction volume is reported in nominal dollars, which just means that those figures aren't adjusted for inflation.
Mark Fleming - And, of course, inflation has been the predominant economic concern over the last three years. And when inflation surged to its recent peak in 2022, it was the highest rate we've seen since the early 1980s.
Xander Snyder - Right, back when Volker was, ahem, the Master of Puppets.
Mark Fleming - Ah, the '80s Music reference. I'm just having visions of Paul Volcker with that, you know, heavy metal hair.
Xander Snyder - Well, rock on.
Odeta Kushi - Alright, rocking and rolling right along here. Typically, when you see a figure that's inflation adjusted, it means that the growth in prices is subtracted from the rate of change in the data point you're trying to measure in order to get a real measure of change. This controls for changes in spending power of a single dollar over time.
Mark Fleming - And this sort of inflation adjustment makes sense when you're measuring things like income or expenses. And it's something that's probably at this point pretty intuitive to folks because consumers have been experiencing it every day when they go to buy groceries, gas, or incur any other daily expenses.
Odeta Kushi - And just to put some numbers to that today, using the headline Consumer Price Index, prices are about 21% higher than they were in January of 2020. That means that with $100, today, you can only buy about 80% as much stuff as you could four years ago.
Mark Fleming - But, the thing is this method of adjusting for inflation doesn't map perfectly into commercial real estate transaction volume. To understand why, think about the costs associated with owning and living in a home. Cash outlays in this case can generally be considered and are often measured as shelter expenses, the cost of living somewhere, but that's not really the case with commercial real estate.
Xander Snyder - That's right. Because commercial real estate commercial properties are almost always purchased as financial assets, where an investor hopes to benefit both from that income earned over time as well as price appreciation. So adjusting the sum total of dollars of commercial real estate transacted by a common inflation index, therefore, doesn't really account for the benefit that investors gained from price appreciation, and price appreciation is an important contribution of their total return.
Odeta Kushi - That's right and, additionally, only looking at nominal dollars transacted fails to account for any additions to the stock of commercial properties. So, for example, if transaction volume in nominal dollars increases, it could be due to either increased transaction activity of the existing stock of commercial properties, or transactions of new additions to that stock.
Mark Fleming - And so, given that inflation has been such a major part of our lived economic experience in recent years, how can we better account for it when looking at transaction activity in commercial real estate markets? After all, declining prices in commercial real estate markets, if measuring transaction volume in dollars, is going to mix the price change with the volume.
Xander Snyder - Exactly. Well, one way is to look, not at dollars spent on commercial properties, but at the total amount of space traded over a period of time. This better accounts for one; new additions to stock, and two; commercial property price appreciation or depreciation over time. After all, what's more real than the amount of space transacted.
Odeta Kushi - So if we're going to make apples-to-apples comparisons of commercial real estate transaction activity over time, looking at space might make more sense than dollars. But, how is space usually measured in commercial properties?
Xander Snyder - Well for non-residential asset classes, like office, industrial, or retail properties, that's in square footage. For apartment buildings or multifamily properties, space is often measured in the number of units traded, although it's worth mentioning that using units instead of square footage is somewhat context dependent for apartment properties. Depends on what you're doing.
Mark Fleming - Okay, so bringing it back to the low, low, low, low limbo, what we can learn about the state of CRE markets today by looking at transaction volumes in space terms.
Xander Snyder - Well, that the market was very slow, slow, slow, slow. Transaction volume in space terms was lower in the first quarter of 2024, then every quarter of 2023. Now that is already a depressed year in terms of commercial real estate deal activity. And so, if we were to look first at non-residential property, so like office, industrial, retail, in the first quarter of this year, approximately 245 million square feet of commercial real estate was traded. And that represents a 30% decline compared to the first quarter of 2023, so a year ago. It was also 13% below the second quarter of 2023, which was the slowest quarter from last year.
Odeta Kushi - When was the last time non-residential transaction volume was this low?
Xander Snyder - Well, the first quarter of this year was the slowest since the second quarter of 2020, when 212 million square feet of non-residential property traded, and now I find this to be a fairly striking data point, the second quarter of 2020, as I'm sure everyone remembers, were the early days of the pandemic when uncertainty was at its highest.
Odeta Kushi - Oh, yeah, I remember that time, it was certainly a challenging time for everyone. In the second quarter of 2020, the economy was temporarily shut down, credit markets were frozen. Quarantine policies were still in effect in much of the country. And people were still figuring out how to broadly adopt remote work practices that have stuck with us to today. It's worth mentioning that back then it was hard to get much of anything done, let alone close large commercial property transactions.
Xander Snyder - Exactly. And that's why I find this data point so eye-catching.
Odeta Kushi - And, unlike back then, the economy today is on relatively sound footing. The pandemic has passed. And, while interest rates are certainly higher than they were, most people know how to work remotely at this point. So that element of disruption has passed.
Xander Snyder - Yet, despite these meaningful differences, commercial real estate volume plunged. What's more, if you look for a similarly slow quarter pre-pandemic, you'd have to go all the way back to the first quarter of 2011.
Mark Fleming - It's clearly been a while since non-residential commercial volume has been this low. Was this the case for all types of non-residential properties? Or did some actually perform better than others?
Xander Snyder - Yeah, interestingly, were it not for an uptick in the volume of retail space traded, total non-residential volume in the first quarter of this year would have been lower than even in the second quarter of 2020. So that means that the quantity of both office and industrial space traded in the first quarter of this year was lower than in the second quarter of 2020. But what offsets that was a nearly three times increase in the amount of retail space traded.
Odeta Kushi - Whoa, so in space terms, a really slow quarter for non-residential commercial real estate outside of retail. What about apartment properties?
Xander Snyder - Well, believe it or not, the decline in multifamily transaction volume was even more severe than for non-residential asset classes. So we're now going to transition to measurements in units, rather than square footage. And in the second quarter of 2020, approximately 102,000 apartment units traded across the country. In the first quarter of this year, only about 84,000 apartments traded, a 20% decline from the most uncertain early days of the pandemic.
Mark Fleming - So, unlike non-residential commercial real estate, fewer apartment properties transacted in the first quarter than at the height of the pandemic. How does that compare to periods before the pandemic? How far back in this asset class do we need to go to get a comparable quarter in terms of apartment units traded?
Xander Snyder - Way back, even further back than for non-residential properties. So the multifamily market has not been this slow for well over a decade. In fact, the quantity of apartments traded has not been this low since the second quarter of 2010. So, even further back than the non-residential properties, and of course back then, the U.S. economy was still reeling from the after effects of the Global Financial Crisis. And back then, in that second quarter of 2010, about 74,000 apartment units were transacted. So this quarter wasn't even all that much higher than all the way back then.
Odeta Kushi - Yikes. Well, I think at this point most people in the industry know what's driving this decline in transactions. Real estate is a credit-intensive business and as interest rates, that is the price of debt goes up, buyers can't afford to pay as much for property. As commercial owners and operators will tell you, a substantial portion of your total return on investment can depend on getting the right price at purchase. On the flip side, sellers are typically averse to realizing losses, so they are less likely to sell at a price that would make an investment profitable for more buyers.
Xander Snyder - Yeah, and in commercial real estate jargon, we'd say that fewer deals are penciling out. Now this gap in price expectation has narrowed some over the last 18 months, but it's still there. And volume won't pick back up significantly until either interest rates fall, which would allow buyers to pay more for properties, or sellers take larger losses and buyers are able to purchase properties at a price that makes their deals pencil.
Mark Fleming - So, based on the latest jobs and inflation data, interest rate cuts are not by any means imminent, the overwhelming majority of the market is still expecting some rate cuts by the end of the year, but now even maybe none of those. And the Fed's been pretty clear that they're willing to keep rates elevated or even hike them if inflation does not make more progress -- 'higher for longer' as they say -- towards the 2% target, or if inflation re-accelerates. But, since we've clearly earned our names as dismal scientists over the last minute or two on this podcast, there must be some good news in the story. Any silver lining that we can highlight?
Odeta Kushi - Help us, Xander.
Xander Snyder - Well, I think the silver lining is that these levels were very likely at or near a trough in transaction volume. Now, that said, transaction volume could easily remain muted over the next several quarters, especially if inflation re-accelerates and interest rates remain 'higher for longer.' At a certain point though, the wall of mortgage maturities that we've talked about on other episodes will remove this wait-and-see option for a lot of sellers. And when there are forced sales that gap in price expectations will narrow further.
Odeta Kushi - I'm going to give you a 'C' in finding silver linings. That was not exactly the most positive story.
Mark Fleming - Well, we can't go low, low, low, any lower.
Odeta Kushi - We'll take it. We'll take it. We certainly put the dismal in dismal science.
Xander Snyder - Yeah, I think the thing to keep in mind is commercial real estate is a long-term investment. And, though we're at the end of a commercial real estate business cycle right now, and there will be winners and losers, the night is darkest before dawn. After this market adjusts and more transactions occur at market-clearing prices, this cycle will conclude and a new one will begin. Smart investors are looking for opportunities to buy in cheap right now at the beginning of what will be the next cycle. And, with sufficient price discipline, they will likely find some good properties to own for the next decade at the right price.
Odeta Kushi - Well, now we know how the phrase stay alive til '25 came to be on the lips of so many in the commercial real estate industry.
Xander Snyder - Yes, indeed. Although, I've been playing with new rhymes for if rates stay higher for even longer than many are hoping for. Here we go. Maybe stay in the mix until 2026.
Mark Fleming - Oh, there's a new one. And that mix may be heard on our REconomy Spotify playlist. You heard it here first, folks.
Odeta Kushi - That's right. And now that we've gotten low, low, low, stuck in your head, listener, we'll end this episode. Thank you so much for joining us on this episode of The REconomy Podcast. If you have an economics-related question you'd like us to feature in the future, you can email us at economics@firstam.com. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark and @XanderSnyderX for Xander. Until next time.
Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.
This transcript has been edited for clarity.
