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How Will Buyers and Sellers Bridge the Current Pricing Gap?

Investors still have a strong appetite for real estate, but still climbing property values are making them nervous about being able to execute on deals.

The pricing gap that has emerged in the commercial real estate market is shouldering much of the blame for slowing transaction volume. How that gap is resolved—and how long it takes to narrow—is a top concern for investors still sitting on a lot of dry powder.

Investors still have a strong appetite for real estate, but still climbing property values are making them nervous about being able to execute on deals. A first half of 2017 survey of alternative asset investors by London-based research firm Preqin found that a majority of respondents, 72 percent, plan to increase or maintain commitments to private real estate funds over the next 12 months. However, 53 percent said it is now harder to source attractive investment opportunities, and 72 percent view pricing and valuation as the key issue facing the industry over the next 12 months.

Many for-sale properties have seen a 25- to 50-basis point adjustment in cap rates over the past 12 to 24 months that is showing up in the bid-ask spread, notes Giacomo Barbieri, managing director and senior regional head of New York investments for TH Real Estate, a real estate investment management firm. Many sellers are stuck on 2015 and 2016 pricing mode and are unwilling to sell if they can’t get the price they want. At the other end of the spectrum, investors are wary about paying premium prices at this late stage in the real estate cycle. “The investor community is kind of tired of unreasonable expectations and spinning their wheels not knowing if there is really a seller at the end,” says Barbieri.

Prices continue to climb

Prices are still trending upward for multifamily, office and industrial assets, while self-storage prices have peaked and retail prices have pulled back, notes Doug Ressler, director of business intelligence for research firm Yardi Matrix. “There is still a lot of capital waiting on the sidelines right now, especially for residential, because multifamily is still the sweetheart,” he says.

According to the latest RCA U.S. National All-Property Composite index, the CPPI index for July is up 7.9 percent year-over-year. Prices on office, industrial and apartment properties are continuing to rise higher, while retail has pulled back with a decline of 1.6 percent.

Yardi Matrix is predicting that cap rates will remain relatively flat. “We do not see significant additional compression,” says Ressler. However, there are some segments of the real estate market that may see more downward pressure due to the high volume of capital chasing deals, such as 1031 investments. Last week the Fed indicated that it would make one more increase in interest rates before year-end. “We believe the market has anticipated the Fed potential impact regarding long-term Treasury rates and has adjusted to Fed intentions,” notes Ressler.

Recalibrating pricing expectations

The emergence of a bid-ask gap is fairly typical in the later stages of real estate cycles. The question is how the gap will get resolved. Will sellers have to come down on price? Will investors go up, or can they meet in the middle?

Some sellers are looking for ways around that pricing gap. For example, TH Real Estate put its 685 Third Avenue property in New York City for sale recently with low pricing guidance that was pushed higher during the competitive bid process. “We didn’t want to go out to the market with unrealistic expectations and not get the attention of investors,” says Barbieri. The 27-story Midtown office property is currently under contract.

On the buy side, high sticker prices are prompting some investors to rethink strategies on where to place capital at this stage of the cycle. “We have a lot of borrowers that we have financed over the years that are seeing [lower] return on the equity side of the business, and they are now investing in UC Funds on the debt side,” says Daniel Palmier, CEO of UC Funds, a specialty finance and investment firm that provides both debt and equity for real estate investments.

The high price/low cap rate environment is also pushing investors to look for bigger returns in new development deals, value-add acquisitions and properties in secondary markets, such as Raleigh, N.C., Charleston, S.C. and Tampa, Fla. “What we really see is value-add picking up, because with minimal capital you can get a property up and going and get a little bit higher rental rate and a better ROI than you can by putting a shovel in the ground and waiting 19 to 36 months to see it come to fruition,” says Ressler.

For example, UC Funds bought two hotels and an apartment property in Downtown Stamford, Conn. earlier this spring for nearly $120 million. One of the assets is a partially developed Residence Inn that was about 60 percent complete at the time of purchase. UC Funds plans to put in another $25 million to finish construction on the 156-room hotel and then operate the completed property.

Even with a visible bid-ask gap on many deals, money is by no means moving to the sidelines. “I think what’s happening is that investment sales brokers are realizing that they need to adjust sellers’ expectations, and do it from the start,” says Barbieri. That will help bring sellers and buyers closer together, but it is likely that that gap will persist and continue to create some softness in the transaction market through the remainder of the year, he adds.

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