Economists refer to a “Goldilocks economy” as one that is neither too hot, nor too cold. Bob Bach, national director of market analysis for Grubb & Ellis, describes 2005 as the year of Goldilocks in the commercial real estate industry. “Economic growth is going to be strong enough in 2005 to propel the leasing market forward, but not so strong as to cause enough of a spike in interest rates that would disrupt the investment market.”
Bach's remarks, which came during a recent Grubb & Ellis Investment Client Conference at the Mandarin Oriental hotel in Miami, preceded a panel discussion moderated by NREI that focused on investment trends.
The vital signs tend to support Bach's Goldilocks theory. Gross Domestic Product (GDP) rose 3.8% in the fourth quarter of 2004, with some preliminary estimates for the first quarter of 2005 as high as 4%. Meanwhile, property fundamentals are improving, though still not terrific. The national office vacancy rate fell 150 basis points in 2004 to close the year at 16.8%.
On the investment side, capital continues to pour into real estate at an unprecedented rate. Over the last seven years, the size of the commercial real estate debt market has doubled from $1.1 trillion to $2.2 trillion, reports PNC Bank. With the 10-year Treasury yield registering 4.26% in late April, it's clear that cheap debt remains plentiful.
“What worries me is that we are in uncharted territory right now,” Bach told the audience of institutional investors and brokers. “As far as I can recall, the commercial real estate market has never really been in a situation like this.” The discrepancy between leasing market conditions and capital market conditions leaves Bach a bit uneasy.
Taking advantage of the hot investment sales market, Atlanta-based Wells Real Estate Investment Trust in April completed a $786 million sale of 27 industrial and office properties totaling 5.1 million sq. ft. The unlisted REIT sold the properties to Lexington Corporate Properties Trust. The deal represents the largest single sales transaction ever by an unlisted REIT. Wells still owns $6 billion in commercial real estate assets totaling more than 29 million sq. ft.
Parker Hudson, senior managing director at Wells Real Estate Funds in charge of portfolio dispositions, and a roundtable participant, said that the timing is right for Wells to rebalance its portfolio. “Maybe some of the properties that we bought when the REIT first began in 1998 and 1999 are in markets where we subsequently haven't gained a critical mass,” said Hudson. “It just makes sense that if we have one building in one particular market, why not sell it and invest somewhere where we have a critical mass?”
Hudson is quick to add that Wells will remain aggressive on the acquisitions front. “We are net buyers of real estate. We hope to acquire close to $2 billion this year, but we will also hope to sell about $1 billion.” That's not surprising. In 2002 and 2003, Wells was the largest purchaser of office and industrial properties in the U.S., according to Real Capital Analytics.
Repricing of real estate?
In this overheated sales market, yield-hungry investors have been forced to lower their expectations. The average cap rate — or initial return on the investment based on the purchase price — has declined 200 basis points to now stand at about 7.5%, according to Nicholas Buss, senior vice president for real estate market research and valuations with PNC Real Estate Finance.
Cap rates will rise as interest rates climb, Buss predicts, but will they spike up 200 basis points or higher? Buss is doubtful because of a trend toward the institutionalization of real estate, and greater transparency, which began a decade ago when equity REITs and CMBS emerged.
“We're basically all working with the same deck of cards in terms of the quality of the information today,” Buss said. “That has really removed some of the volatility. It's also removed the pricing premium that had resulted from investors' lack of knowledge.”
For a complete transcript of the Grubb & Ellis Investment Client Conference roundtable, go to nreionline.com