HFF Research Update for October 6, 2016: Like A Rolling Stone

Weekly insights on current research in the commercial real estate industry from HFF Managing Director of Research Jimmy Hinton. View Daily Rates on the HFF website or access the HFF Daily Rates App in iTunes.

In 1965, Bob Dylan penned a manuscript that struggled through a difficult adolescence.

In the studio, Dylan couldn’t find the right melody, the right pace or the right key for what eventually would become one of the most widely-heralded and influential songs of its era. As is typical with great records, the finished product was starkly different than the artist’s original concept. Thematically, the words spoke of a fall from grace with an air of provocation. Such a song couldn’t be commenced softly; yet finding the right entre was elusive.

“This song is going to put me in my grave,” Dylan would say while performing an early iteration of the tune live. After his guitar-turned-organ player Al Kooper improvised an organ riff, Dylan asked that its volume be turned higher in the mix, and, suddenly, Dylan had “Like A Rolling Stone,” which didn’t necessarily put him in a grave but in the Rock & Roll Hall of Fame.

Ahh, princess on a steeple and all the pretty people
They're all drinking, thinking that they've got it made
Exchanging all precious gifts
But you better take your diamond ring, you better pawn it, babe

Dylan rubbed the subject’s face in its reversion. Aside from the catchy melody and the infectious “How does it feel?” rhetoric, I find myself looking back on the lyrics he wrote and questioning the state of our industry. Will we soon wish we hadn’t taken our diamonds for granted? Do we think we have it made but we don’t see something more sinister lurking?

By now you are familiar with the many metrics HFF uses to dispel such notions. Recently, HFF delivered its thesis to Wall Street, and it appears they agree.

This morning in a note to clients, Goldman Sachs said “[their] biggest takeaway is that the state of U.S. commercial real estate is in line with the state of the U.S. economy. Growth is positive, but decelerating. Going forward, CRE is likely to move in line with changes in overall economic growth. There are not factors specific to CRE (excess leverage, excess supply, regulation, etc.) that would cause the asset class to significantly disconnect from underlying economic fundamentals.”

Other noteworthy takeaways include:

  • Supply and demand are in balance. Rent growth is moderating but it still remains healthy. Supply growth, but for a few pockets, is well contained and remains below the long-term average. The ability of investors to add new supply, due to tightness in construction lending markets, has been seriously curtailed. In a “slow and steady” market environment, it is reasonable to think that landlords will continue to benefit.
  • Interest from foreign investors remains high. Overall investment in U.S. CRE from foreign investors is down meaningfully from 2015, but 2015 sets an incredibly difficult comparison. Foreign investors paused on making new investments in early 2016, but this was done in lockstep and for similar reasons as domestic investors in CRE. The U.S. CRE asset class remains attractive to foreign capital.
  • Institutional interest in CRE has rebounded with sentiment on the economy. HFF notes that institutional concern and planning for end of cycle risk is beginning to be overshadowed by investors managing reinvestment risk. During the 1Q 2016 financial market disruption, open-end CRE funds saw inbound queues fall from $12 billion to approximately $3 billion, while a $5 billion outbound queue materialized (investors in open-end funds need to give prior notice before investing or withdrawing from funds). HFF notes that the outbound queue has now disappeared while the inbound queue has modestly improved.
  • Bank lending remains robust, despite regulatory concerns. Overall bank lending into CRE has increased by 38 percent in 2016 (originations through 2Q, measured by the Mortgage Bankers Association). This has largely offset the pullback in CMBS lending, driven in part by regulatory pressure (CMBS originations are down 29 percent year over year per the MBA). Banks continue to have a robust appetite for CRE term lending, and pricing continues to be competitive. Regional banks, in particular, remain active in the asset class. Bank lending is being supplemented by robust growth in “shadow bank” lending into CRE; HFF expects shadow bank lending to play an increasing role in financing CRE going forward.
  • There has been a pronounced pullback in construction lending. Regulatory pressure appears to be having the most pronounced impact on bank lending into CRE construction. In general, construction lending is “very very difficult” to get done. The pullback in lending is broad based (beyond just multi-housing), though multi-housing may feel the most pain, as credit had been so widely available for construction up until recently. HFF did note that smaller, bite-sized, developments (like industrial) remain relatively easier to finance. Hotel and office remain the most difficult to finance.
  • The long-term outlook for CRE transaction volumes is quite strong. Current weakness in transaction volumes is a result of the bid/ask gap between buyers and sellers, but these gaps are temporary in nature (generally six to nine months). The market is now nine months in to the current pricing disconnect. The long-term outlook remains positive, which is why HFF has accelerated its investment in people and technology. The underlying ownership of commercial real estate has become increasingly institutional (the value of CRE owned by closed-end funds, as an example, has increased by 90 percent from the prior peak). These institutional owners are more transactional in nature, driving the potential for CRE transaction volumes well beyond levels realized during the prior market peak.

On Goldman’s topic of underlying fundamentals, Initial Claims for Unemployment Benefits fell to levels not reported since 1973. Covered in HFF's BLS Employment Situation report each month (the September update will be published on this blog next week), initial claims help economists understand the pace of new layoffs while continuing claims help convey the ability for out-of-work members of the labor force to reemploy themselves. Directionally, the initial claims report is accretive to confidence, and the four decades that have passed since a sub-250,000 report is pretty remarkable.

In summary, real estate much like the broader economy continues to roll along, like a rolling stone, even if in a different meaning than Mr. Dylan intended.

Source: HFF Research, Bloomberg, Bureau of Labor Statistics, Goldman Sachs

About Jimmy Hinton

Jimmy Hinton serves as Managing Director of HFF, responsible for the firm’s national research efforts. Mr. Hinton works with the executive management team to assist in investor relations and to inform both HFF staff and firm clients with in-depth analysis of economic, property and capital market trends. He is also responsible for providing extensive market reports, client presentations and deal-specific analysis for debt placement and investment sales assignments. Mr. Hinton’s responsibilities include substantial interaction with pension funds, life insurance companies, regional and CMBS lenders, REITs, foreign investors and private equity funds.

During his tenure at HFF, Mr. Hinton has supported the execution of more than 150 commercial real estate transactions totaling more than $4.5 billion in 20 states. Mr. Hinton has experience in fixed- and adjustable-rate debt, mezzanine debt, construction loans and joint venture executions on behalf of clients engaged in the acquisition, development and recapitalization of property types including multi-housing, industrial, office, retail, medical office and storage properties.

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