What Will Real Estate Capital Markets Look Like in 2011?

by CoyDavidson on December 16, 2010

Research Matters

By: Ross Moore | Chief Economist, Colliers USA

This is the second in a series of 2011 projections examining some of the key trends that will likely drive commercial real estate markets in 2011. Early next week, the final part in the series will examine the cities across the country that are most likely to the lead the real estate recovery.

Signs of Improvement Should Drive More Sales in 2011

With total investment volume for 2010 set to register $100 billion, all the elements are in place for investment sales to increase further in 2011.  Although still far below peak 2007 levels of $514 billion, 2010 transaction volume represents a near doubling over 2009. For 2011, all the ingredients are in place for investment sales to increase further, rising at least 20%. A combination of strengthening leasing fundamentals, further improvement in credit markets and still low borrowing rates should result in more offerings and a gradual uptick in values. Demand for hard assets, and in particular those that are income producing, is expected to be exceptionally strong from all types of investors.

But What About Pricing?

As the chart below shows, after the recent peak in 2009 cap rates have been trending down for most of 2010, supporting prices and demonstrating how investors have been aggressively bidding up prices in anticipation of improving fundamentals. The accompanying chart also shows how 10-year Treasury yields have remained relatively low over the past few years and helped contribute to downward pressure on borrowing costs and to encourage investors to return to more risky investments, including real estate. The latest Moody’s Commercial Property Price index shows a more mixed picture with prices up just 0.3% over the past 12 months, but the trend clearly shows the free-fall in prices from late 2007 through until early 2009 are now over. Looking forward to 2011, capitalization rates are expected to continue their downward march but the possibility of rising borrowing costs is a distinct possibility and could act as a substantial headwind. In just the last month, the yield on 10-year Treasury notes has increased a full percentage point to register 3.50%. Our view is Treasury rates could continue to climb, possibly reaching 4.00% but this should be viewed as a sign that the economy is getting stronger, not a return of inflation, or at least not a sign that inflation will return anytime soon. Higher Treasury rates will put upward pressure on interest rates but spreads could also narrow helping to cushion the upward move in Treasury yields.

2011 Could See a Fair Amount of Distressed Real Estate Come to the Market

After very little distressed real estate coming to the market, a combination of factors including regulators, price discovery, more liquid markets and the legal and fiduciary issues associated with distressed properties, the market should begin to see a fairly large amount of impaired real estate placed on the market. Distressed sales for much of 2010 accounted for less than 10% of total sales, but recent data shows troubled real estate assets now make up 15% of total transactions and by early 2011 distressed sales could account for as much as 20-25% of total sales. With the banking sector showing signs of stabilizing, the “extend and pretend” phenomenon is expected to taper off. Failed banks are still a concern for regulators, but 2010 failures are not expected to top 160, representing just a 14% increase over 2009.

Commercial Real Estate Could Find Itself in the Sweet Spot in 2011

Investors are migrating to hard assets and also seeking a hedge against inflation. Investors should be very encouraged by fundamentals that are sure to get better in both the short and medium term. The economy and labor markets appear set to improve in 2011. If long term interest rates do rise significantly above 4.00%, and stay there for an extended period of time, commercial real estate will lose some of its luster, but this is not part of our base-case scenario. Far more likely will be a market characterized by historically low interest rates, a growing economy and very limited new supply. For most investors, 2011 will be a reasonably good year to own income producing real estate.

Ross Moore is the Colliers International’s Chief Economist with a focus on providing bottom-up and top-down analysis of commercial real estate markets across the United States. In addition to his North America wide reports, Ross also authors all global research produced by Colliers.

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