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Is a commercial real estate correction in the cards?

Recent reports suggest that  the good times are continuing for the commercial real estate market, but some analysts are worried that too much cash is being thrown at properties, and asset prices are too high.   

The phrases “market pause” and “correction” are showing up more in reports that otherwise point to strengthening fundamentals and strong sales and investment activity.

During a webcast hosted this month by Deloitte, for example, Situs RERC President Ken Riggs expressed this concern.

“Something is going to happen,” Riggs said. “We don’t know what it is and the exact timing of it, but there will be a market correction.”   

Riggs said market conditions were still “manageable,” with properties priced about right in most markets, but he added that any further run-up in prices over the next 12 to 16 months “will set ourselves up for a major market correction.”

David Kidder, president of the California-based Landmark Capital Advisors, said lenders and investors “are skittish.”

“It is more challenging to get deals done, yet I don’t think the assets trading hands or being refinanced have slowed down,” Kidder said during a telephone interview. The heavy flow of cash into commercial real estate has been driven by foreign investment and low interest rates. He said if one or both those factors change, the market could see a correction across all sectors and parts of the country.

“There is some legitimate concern,” Kidder said. “We have been in what everybody has been recognizing all along as an artificially inflated environment.”

He said a slowdown in sales or slight correction in prices, however, could be healthy for long-term growth.

“I think people like to remain positive, but they are concerned,” Kidder said. “You have been winning and winning and winning. At some point, you want to take your chips off the table and be a little bit cautious in how you approach things.”  

MBA forecasts record year in 2016

The forecasts continue to point to a busy market lasting through this year. The Mortgage Bankers Association has predicted a record year for origination volume in 2016, at $511 billion, up 3 percent from 2015 and exceeding the 2007 total of $507 billion. In a report last month, Real Capital Analytics said sales transactions picked up steam in the final quarter of 2015 after the normal seasonal lull in the third quarter.

National Association of Realtors commercial analyst George Ratiu acknowledged that people are worried, however.

“Yes, there are concerns in the market,” Ratiu said. “Most of them stem from pricing, and a lot of investors are concerned that prices are becoming exuberant simply because there is so much cash looking for not enough inventory.”  

 Based on repeat sales, large assets valued above $2.5 million reached a new price peak in 2015. Smaller-asset properties, however, have still not surpassed the peak level.

“In the current economic environment of slugglish growth, when you have anything remotely getting close to or touching 2007 [levels], which was viewed as an exuberant economic and real estate environment, people get nervous,” Ratiu said.  

Ratiu said investors still have good reasons to be optimistic that the market will avoid a major correction this year, however. He noted that leasing trends have improved and the vacancies rates still have room to decline and boost revenues. He said lenders are still showing considerable discipline.

Ratiu also said the current commercial real estate market has not been driven by loose financing standards. He said the percentage of the deals tied to commercial mortgage-backed securities is nowhere near as high as it was at the height of the market in 2007. Whereas the CMBS share accounted for nearly 50 percent of the loan volume back then, it is less than 20 percent now, Ratiu said. The flow of capital has been more evenly distributed among the investor classes, he said, and lenders are generally keeping more debt on their books and have “more skin in the game.” This is keeping underwriting standards in check, he said.  

“If  you look  back at 2007, the discipline of capital, of real estate in general, residential and commercial, was much looser than it is today,” Ratiu said.