In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Senior Commercial Economist Xander Snyder explain why there are some glimmers of light in the commercial real estate market for the first time since 2022.
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Listen to the REconomy Podcast™ Episode 99:
“Part of why credit availability has been limited over the last two years is that asset valuations have been so ambiguous, so that gap in price expectations. An uptick in lending is, therefore, a sign that lenders are feeling increasingly certain of their ability to value the collateral that they're lending against. So, for commercial properties, while that doesn't mean that the process of price discovery is over, I do think it means that this gap we've been talking about has narrowed sufficiently for certain types of transactions to be taking place more regularly.” – Xander Snyder, senior commercial economist at First American
Transcript:
Xander Snyder - Hello and welcome to episode 99 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Xander Snyder, senior commercial economist at First American, and here with me is Mark Fleming, our chief economist. Hey, Mark.
Mark Fleming - Hey Xander, and a warm welcome back to all of our listeners. We hope you got a chance to tune into our Summer School series that covered a number of core real estate concepts. With Fall now here, we're turning back to our regularly scheduled programming, but as you'll soon see, all of those ideas are going to come back around, which reminds me of a song. You spin me right around, baby.
Xander Snyder - Right around. What a relief we're getting that 80s reference out of the way, early today, Mark.
Mark Fleming - Exactly.
Xander Snyder - So with Summer School now over, Odeta is on her summer vacation, so I'll be filling in today, but she'll be back for the next episode, which will be a special one -- the 100th episode of The REconomy Podcast.
Mark Fleming - That's right. This all started as a way to have interesting conversations more regularly during the height of quarantine, but we just couldn't stop there, and now it's reaching triple digits. To celebrate our centennial episode, we'll do a little retrospective on predictions we've made in the past, as well as some of the most common questions we've received from listeners over the years. So be sure to tune in for that one. But, for today, how are we going to be applying our new Summer School chops, Xander?
Xander Snyder - Well, in episode 95, which was the fourth Summer School session, we covered the concept of capitalization rates, more commonly referred to just as cap rates, and why they're so important in the commercial real estate world. Cap rates tie together the two types of returns that owners of commercial real estate hope to realize, income and price appreciation, and for that reason, they act as both a measure of yield generated by a property and a valuation tool. Given some income stream, you can back in to what that property is worth using a cap rate.
Mark Fleming - Cap rates can feel a little counterintuitive at times, since high cap rates actually reflect lower property valuations, if income is held equal. As a quick example, a property generating $100,000 in income that's worth a million dollars has a 10% cap rate. If income doesn't change, but the value of the property falls to 800,000 that property would then have a 12.5% cap rate. In effect, higher cap rates are an indication that investors are less willing to pay for income streams generated by commercial properties, while lower cap rates mean investors are more willing to pay up to acquire that income stream.
Xander Snyder - That's right. And, in fact, cap rates are so important in the commercial real estate world that we built a model called the First American Potential Cap Rate Model, or just PCR for short, which models an actual national cap rate based on a number of market fundamentals. Today, we'll be talking about multifamily cap rates, and referring mainly to our multifamily PCR, which models multifamily cap rates. The market fundamentals we use in the multifamily PCR include transaction volume, debt flows and renter household formation.
Mark Fleming - That's right, and it turns out that our multifamily PCR is emitting glimmer of light and suggesting that multifamily cap rates are finally falling in the third quarter. Also, I can't help making a little plug here, we first published our second quarter results on First American's Economic Center in late August, so our subscribers would have received them when they were first published. So, if you want even more timely real estate data and analysis, be sure to subscribe to our Economic Center.
Xander Snyder - First American's Multifamily PCR model forecasted a slight decline to a level of 5.7% in the third quarter, down from 5.8% in the second quarter. And, while a 0.1 percentage point decrease isn't a huge drop, it would still be the first time that multifamily cap rates have declined since the first quarter of 2022.
Mark Fleming - And to get a sense of why falling multifamily cap rates would be such big news, let's take a brief look at the history of those cap rates over the last 15 years. After the Global Financial Crisis of 2008 to 2009, multifamily cap rates steadily declined for more than a decade, from the third quarter of 2009 to the first quarter of 2022. Declining cap rates, which typically correspond with increasing property prices, plus a very-low interest rate environment throughout the same period, acted as dual tailwinds for commercial real estate. Investors could, with some degree of certainty, buy a property and expect to sell it later at a lower cap rate to a buyer who was still able to secure cheap financing.
Xander Snyder - And the result of this decade plus long, secular decline in cap rates meant that, even if a building operator was unable to increase the income generated by a property while they own that property, then falling cap rates would still translate into a gain on that investment at sale. Now, if you could increase income and sell at a lower cap rate than when you purchased that, you could stand to make a good profit.
Mark Fleming - Now, we're economists, so on the other hand, this means that cap rate increases, which began in mid-2022 were a major reversal from that trend from the previous 13 years. From some perspective, many professionals who started their careers in commercial real estate in 2009 or later, that is after the Financial Crisis, had never experienced an environment of increasing cap rates, which has now been the case for the last two years. So, what made cap rates reverse course and begin to increase in 2022? Well, it might be tempting to simply point at the Fed's interest rate hikes that also began that year and call it a day, but a number of studies now suggest that cap rates are only modestly correlated with interest rates. The real driver behind increasing cap rates was falling demand to purchase commercial properties. And, while the higher cost of debt certainly played a part, it wasn't the only part, or even possibly the primary part, in the rising cap rates that we've seen in the last couple of years. When demand for some asset, like a commercial property, falls, the return on that asset must increase to attract additional demand, right?
Xander Snyder - Higher cap rates weren't just an interest rate story. Another major driver of decreasing demand to own apartment properties was the gap in price expectations between buyers and sellers that formed when transaction volume fell. Now, as volume fell, in part due to higher financing costs, prices for properties that were selling decreased quickly. By late 2022 to early 2023, many sellers remained anchored to the sky-high prices observed in 2021 and so were hesitant to sell for less than what had recently been possible. But the demand to buy simply wasn't there, and that gap in price expectations kept many buyers on the sidelines, wary of catching the proverbial falling knife if prices continue to decline. What's more, with Treasury yields higher than they had been in decades, prospective buyers were typically willing to earn a safe return by parking money in treasuries or something similarly liquid, and just waiting for property prices to adjust down. With a number of commercial property mortgages coming due, time was on the buyer's side, not the seller's side.
Mark Fleming - So, if we come back to the present, what is it about the multifamily PCR that's indicating that apartment cap rates might be at another inflection point?
Xander Snyder - Well, Mark, since we're talking about future cap rates, wouldn't that mean that we're going back to the future?
Mark Fleming - A double '80s reference episode. We are just getting warmed up for our centennial episode, and one of the classic films of that decade.
Xander Snyder - It sure was. So, it does seem like multifamily cap rates have risen high enough at this point to begin to attract more buyers back into the market. In dollar terms, multifamily transaction volume in the second quarter increased by 20% on an annual basis, the first such annual increase in seven quarters. Though, approximately $10 billion of that transaction volume was from a single, large entity deal. The fact that this deal happened at all is a sign that very large buyers are becoming more active at current cap rate levels.
Mark Fleming - And, speaking of larger deals, there's also been developments in lending markets for larger properties. That suggests that cautious optimism is warranted, right, Xander? After all, we call this episode glimmers of light, plural. What other data can we point to, in addition to stabilizing or declining multifamily cap rates, that suggest we may be at or near a turning point?
Xander Snyder - Yeah, that's right. According to data from the Mortgage Bankers Association, commercial real estate loan originations were up by 3% in the second quarter compared to a year ago. While this seems like a modest number, it's the first increase in commercial real estate origination activity of over a percentage point since lending slowed back in 2022. The increase, though, was driven primarily by a substantial, approximately 150% annual increase in originations of commercial mortgage-backed securities or CMBS. CMBS are typically used to finance very large properties or portfolios of properties, and they pull together the money of many different individual investors into a single security that can then be more easily bought and sold than other types of commercial real estate debt.
Mark Fleming - So, this spike in CMBS origination is yet another data point suggesting that larger transactions are again taking place more often.
Xander Snyder - That's right. Big buyers are at least beginning to become more active than they were last year, and large loans are becoming more common, suggesting that buyers are starting to move off the sidelines and re-engage. It's worth noting that CMBS wasn't the only type of loan for which originations increased in the second quarter, loans originated by investor lenders, who lend their own money, and agency lenders, like Fannie Mae and Freddie Mac, also increased origination activity. Meanwhile, banks who lend depositors' money, as well as life insurance companies, decreased originations to the commercial real estate market.
Mark Fleming - So, all these different sources increasing lending activity has a few other implications that are worth talking about. But first, just to clarify, you mentioned that investors are involved in both CMBS and investor-originated loans. What's the difference between these two?
Xander Snyder - Yeah, this is a great example of the jargon getting a little confusing. So investor lenders typically loan out all, or the majority of the loan being originated, and retain that loan throughout its life. Occasionally, they will share these loans with a handful of other private lenders, but CMBS involve many, many investors whose capital is pooled together into single securities that are traded more regularly than private loans originated by investor lenders. Since CMBS pool many investors money together, they're often larger than individual investor-made loans.
Mark Fleming - That makes sense. So, more lending raises the prospect of growing credit availability to the CRE industry, and since most commercial properties are bought with some type of a loan, greater credit availability enables greater buyer demand for commercial real estate. But it also means that lenders are at least beginning to feel more comfortable with asset values, which have been highly uncertain, particularly in certain asset classes, over the last two years. So, it seems like that price gap between buyers and sellers may be narrowing.
Xander Snyder - Yes, I definitely think that's the case, at least for most property types. Unlike property owners, lenders have limited upside. The only return they can make is the interest payments from their loan. At the same time, they stand to potentially lose a substantial amount of money if their borrower defaults, and for whatever reason, they can't fully collect on the collateral value. This typically makes lenders quite risk averse. Part of why credit availability has been limited over the last two years is that asset valuations have been so ambiguous, so that gap in price expectations. An uptick in lending is, therefore, a sign that lenders are feeling increasingly certain of their ability to value the collateral that they're lending against. So, for commercial properties, while that doesn't mean that the process of price discovery is over, I do think it means that this gap we've been talking about has narrowed sufficiently for certain types of transactions to be taking place more regularly.
Mark Fleming - I sure am glad I did my studying in Summer School with that cap rate episode, Xander. Does this mean that we don't have to be commercial dismal scientists anymore? I have to admit, Xander, that positive news from the commercial real estate world has been in short supply lately.
Xander Snyder - Yes, I think we're getting closer, but the commercial real estate market is more like an ocean liner than a speedboat. It turns slowly. I think the prospect of multifamily cap rates stabilizing, or even beginning to decline, and lenders stepping back into the market certainly reflects some glimmers of light at the end of this tunnel, but the market can nevertheless remain at a trough for several quarters. And, indeed, that's what happened in the aftermath of both the Global Financial Crisis in 2008-2009, as well as the savings and loan crisis in the early 1990s, when commercial property prices declined for nine consecutive quarters and 16 consecutive quarters respectively.
Mark Fleming - All right, I like this Back to the Future view that we have for CRE in the coming months. And thank you for joining us on this episode of The REconomy Podcast. If you have an economics-related question you'd like us to feature, you can email us at economics@firstam.com. And, as always, if you can't wait for the next episode, follow us on X. That's @XanderSnyderX for Xander and @MFlemingEcon for me. 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.
