It is official. The years of cap rate compression in commercial real estate are over and the sector is in a downward spiral that is expected to last through most of 2008, says ING Clarion.
On Tuesday, the New York City-based global real estate investment firm announced commercial real estate investors are no longer deploying capital indiscriminately as the credit crunch tightens, home values decline and commodity prices rise, colliding to wreak havoc on the U.S. consumer and economy.
While there was no debate on whether we are in a recession during its press conference, ING Clarion's chairman and CEO, Stephen J. Furnary, said it was clear the U.S. economy is suffering, citing fourth quarter 2007 GDP growth of just 0.6 percent compared to 4.9 percent in 2006. In addition, unemployment rose to 5 percent last year, its highest level since 2005, and continued its climb during the first quarter of 2008, shedding an estimated 43,000 jobs in January and February.
Amid the glum forecast, researchers pointed out a reason for cheer. The good news is the downturn will be brief. Commercial real estate values are projected to bottom out in the third quarter and rebound in mid-2009.
“The most likely scenario is a short, V-shaped recession," said David Lynn, managing director of research and investment strategy with ING Clarion.
The retail sector will be hardest hit because of its dependence on consumer spending. Over the past few years, rising home values allowed Americans to fund purchases by borrowing against the equity in their homes. Now, with approximately $2 trillion in home equity vaporized, that trend has ceased. Standard & Poor’s/Case Shiller Home Price Index, which measures home values in 20 metropolitan markets nationwide, fell 12.7 percent for the year ended February; signaling the worst housing downturn since the late 1980s.
In March, the Deloitte Leading Index of Consumer Durables Spending, published by the New York City-based professional services firm Deloitte, fell for the sixth consecutive month, signaling sinking sales of consumer electronics, furniture and home improvement items. When you factor in surging gas and commodity prices, as well as swelling unemployment, consumer spending could register negative growth in 2008, Lynn added.
As a result, vacancy rates in the retail sector will continue to rise and rent growth will moderate. In the first quarter of 2008, the average vacancy rate for U.S. shopping centers reached 7.7 percent, the highest level in more than a decade, and effective rents grew just 0.1 percent, according to Reis, Inc. ING Clarion's research shows, between now and 2011, effective rent growth for retail properties will remain below 3 percent.
The commercial real estate sector, however, has still not felt the full impact of the downturn, according to Furnary. Since last summer, at the onset of the credit crunch, cap rates on commercial real estate assets have moved up just 10 basis points to 40 basis points, cites ING Clarion's research. Class-A assets in core markets experienced cap rate increases between 25 basis points and 30 basis points. However, by 2009, cap rates are expected to rise another 30 basis points to 60 basis points, fueled by re-pricing of risk and the exodus of speculative investors.
For institutional quality retail assets, ING Clarion's report shows, average cap rates will rise 30 basis points to 60 basis points this year, to 6.3-6.6 percent, from 6 percent in the fourth quarter of 2007.
“The story going forward will be how you manage your [existing] properties,” said Lynn.