HFF Managing Director of Research Jimmy Hinton and Research Analyst Laura Haltom analyze the state of the April 2019 capital markets. Our research team analyzes trends and data to give readers the most up-to-date information affecting commercial real estate.
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The real estate capital markets have matured since the last recession. Despite the surge in institutional dollars, alongside robust fundraising from closed- and open-ended funds, investors have remained cautious. Institutional investors are approximately 100 bps below their investment target, demonstrating discipline amid resolve, and dry powder awaiting deployment stands at a staggering $210 billion. Further, surveys suggest interest from these players have increased in 2019.
There is certainly good reason for interest: The common proxy for the private real estate market, the NCREIF Property Index (NPI), has outperformed standard indices representing equities, debt, REITs, commodities and U.S. Treasuries over a 15-year period. And, when volatility of returns is taken into consideration, the NPI comes out even further ahead of the competition with the highest/best Sharpe Ratio among its peer set listed above.
The increasing interest in real estate underpinned the market’s record $576 billion transaction volume in 2018. Though volumes were similar (+1%) to those seen in 2007, two-thirds of last year’s transactions were comprised of individual sales, the category with the least variation in volume over the last 17 years. This contrasts with 2007, when only half of all volume was comprised of individual sales – the remainder from more volatile entity and portfolio sales. Calendar year 2018’s transaction composition suggests the possibility of more stable capital flows in the future.
The recognition of real estate as a separate Global Industry Classification Standard (GICS) category in 2016 helped underpin investors’ interest in real estate, as well as the perceived validity of the investment class. A resultant increase in available capital sources has helped grow transaction volumes and real estate investment further with offshore investors increasing their geographic and property type exposures by 56% since 2007, along with an emerging interest from family offices in real estate investment in parallel.
The growth and maturity of the real estate industry can be seen, too, through robust and diversified available debt capital. 2018 saw record mortgage originations, at $574 billion with positive growth by all lender types excluding CMBS. Multi-housing was clearly the favored property type comprising approximately 45% of total originations.
Investment in nonresidential structures has been historically slow this cycle. With higher construction and labor costs as headwinds, new building construction looks to stay muted in the short term.
With the demonstrated high demand and caution shown by investors, in parallel to constraints experienced by builders, valuations are likely to remain healthily competitive.
According to the NPI, income returns have accounted for around two-thirds of total property returns over the past few years, with remaining returns due to appreciation. As income returns are traditionally much more stable than appreciation returns, present conditions suggest that properties are well positioned to take advantage of such stable returns in the coming years. Still, an asset’s return may be mostly realized through its exit cap rate. With cap rates having fallen broadly since 2010 and with the FOMC’s four rate increases in 2018, the potential for a rise in cap rates triggered by these rate increases honed investor focus on forecasted NOI growth – the lower the cap rate, the higher NOI growth necessary to neutralize property devaluation. While NOI growth is still of high importance, the current lull in rate increases may stymie the potential for cap rate volatility for now.
Sources: HFF Research, Cornell University, National Council of Real Estate Investment Fiduciaries, Preqin, Real Capital Analytics, Mortgage Bankers Association, Commercial Mortgage Alert, American Council of Life Insurers, U.S. Bureau of Labor Statistics, U.S. Census Bureau, Wells Fargo, Morgan Stanley, CoStar Market Analytics and Hodes Weill.