Featured ExpertOur Perspective 1/ 10/ 2017

West Coast performing above par in final innings of CRE market

Many industry experts have labeled this past year the seventh or eigth inning of the cycle. Does that mean the cycle will conclude in 2017? Only time will tell, but at a minimum all signs point towards a year of transition.

The following should have a big impact on multifamily investment and valuations in 2017:

  • Change in government policy dictated by the new administration
  • Higher short-term and long-term interest rates
  • A slowdown in rent growth and absorption, especially in the newer, high-end buildings

These factors will be counterbalanced by the abundance of capital available chasing both equity and debt, and strong employment growth in most West Coast markets. Recent reports by Yardi and Zillow suggest the West Coast markets are outperforming the total US market with greater rent increases over the past twelve months and projected increases for 2017. According to Zillow, the biggest increases are expected in the following West Coast markets:

  1. Seattle: 7.2%
  2. Portland: 6.0%
  3. Denver: 5.9%
  4. Cincinnati: 5.2%
  5. San Francisco: 4.9%
  6. Los Angeles: 4.8%
  7. Sacramento: 4.7%
  8. San Diego: 4.7%
  9. Phoenix: 4.6%
  10. San Jose: 4.5%

 

In the week following the election, the 10-year Treasury rate jumped more than 50 basis points and the stock market increased roughly 5 percent. Treasury rates are now 100 basis points above the 2016 bottom of 1.37 percent, which was in early July. Few predicted this rapid spike in interest rates but that’s usually the way the market works. In recent history, a rate increase of this magnitude does not necessary cause a basis-point-for-basis-point increase in market cap rates. There have been enough cash buyers or buyers who use short-term rates to dilute the effect of a quick spike in interest rates. We should also remember the 10-year Treasury was as high as 2.3 percent in December of 2015. However, the recent move was substantial enough to cause a moderate adjustment in what most buyers are willing to pay and we are hearing of a number of transactions that are currently being re-priced/re-traded.

The industry should have a better idea of where rates are headed after the December Federal Reserve meeting where expectations of a short-term rate increase have been hovering between 80-90 percent. It will probably be another three to six months after that before we know the full effect of rates on pricing, assuming rates remain where there are today.

In theory, investors should be adjusting their returns using current interest rates, higher exit caps, higher vacancy and lower rent growth. Real estate and especially multifamily real estate, however, has looked good for a long time, relative to other asset classes. The big question is: Will demand from institutional and private capital be strong enough for investors to accept lower returns or will sellers adjust to the new fundamentals and accept lower pricing?

The lending cap for Fannie Mae and Freddie Mac was announced November 22 and is going to be unchanged from $36.5 billion each in 2016. The agencies have a track record of doing what needs to be done to insure they reach their lending limits. If the ten-year rate remains at its current level of 2.3 percent, it is possible spreads will compress slightly to maintain loan volume. In addition, the agencies are expected to do another $15-20 billion in uncapped business, which includes affordable, green and manufactured housing.

In the first quarter of 2017, we will all be watching interest rates, rents and absorption rates in the new product. Nationally, Axiometrics expects rents to increase 3.4 percent by the end of 2016 and 2.1 percent in 2017. This is down from the peak of 4.6 percent in 2015. In 2016, 337,000 new units will open and another 270,000 are expected to come online in 2017.

This time last year, it seemed far easier to predict what the multifamily market would look like six months downstream. But, greater uncertainty leads to more opportunity for those who are patient, resourceful and creative. The good news is there should be plenty of opportunity for everyone in the coming New Year!

NOTE: Portions of the above analysis were published in the January 2017 edition of Western Real Estate Business.

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