Investor Optimism Compressing Cap Rates for Properties with Performance Durability, Strong Recovery
Health and economic outlooks improving. Multiple factors point to an economy that is firmly in recovery as vaccinations continue. A number of stimulus checks and new support programs such as federal unemployment insurance have helped to lessen the financial burdens of those most impaired by the health crisis. For those who were able to keep working, stimulus measures and fewer consumption options have bolstered personal savings. The total value in savings deposits and money market funds has increased an estimated $4.3 trillion since February 2020. These pent-up savings are giving way to heightened retail spending as more venues reopen. Core retail sales have grown 13 percent from the February 2020 pre-pandemic benchmark. Reviving air travel suggests that both business and leisure travelers are also back on the move.
Varying performance restrains overall marketable inventory. Strengthening economic tailwinds should boost commercial real estate fundamentals this year, inciting recovery speculation among investors and spurring buyer activity. At the same time, the recovery has thus far been uneven, with some cities, states and property types jumping ahead of others, generating a broad range of valuation variance. Many owners remain in a holding pattern, awaiting additional clarity before they sell, which is restraining the flow of marketable inventory. This demand-supply unbalance has exacerbated the expectation gap between buyers and sellers in many markets, slowing deal flow for underperforming assets.
Competitive bidding spurs cap rate compression. Buyers have most aggressively focused on assets that weathered the pandemic best, including many industrial, multifamily and self-storage properties. Investors have also targeted property types expected to make a quick post-crisis recovery, such as hotels as well as certain types of retail and seniors housing. While some discounting has occurred in unique situations, valuations of most asset types have largely held steady or surpassed pre-health crisis levels as strong buyer interest has aligned with limited for-sale inventory. This dynamic has also led to cap rate compression among sought after assets.
Commercial property yields offer compelling margins. A limited number of marketed assets is supporting price appreciation and cap rate compression in regions with a positive growth outlook. Despite these contracting yields, the margin remains wide relative to alternative low-risk investment vehicles. Interest rates are still historically low, with the 10-year Treasury rate trailing the average commercial property cap rate by over 400 basis points. As the economy reopens, investment demand profiles are strengthening, and that anticipated momentum will carry over into markets and property types that have faced more recent hurdles.
Recovery Expectations Improve Investor Optimism for the Urban Core as Suburbs Respond to Demographic Shifts
Multifamily performance varies based on market. Apartments in large primary metros have been more impaired by the health crisis than properties in smaller cities. Vacancy across all primary markets increased 80 basis points over the past four quarters, while the average effective rent declined 3.4 percent. Secondary and tertiary markets have fared better, with a 10-basis-point vacancy decline and rent growth of 2.2 percent over the same span. Migration trends driven both by the pandemic as well as the aging of the millennial generation are affecting performance. More than half of millennials are 30 years of age or older, common family formation years, spurring demand for larger, more affordable living spaces outside the urban core.
Apartment pricing surpasses pre-pandemic levels. In numerous markets, well-per-forming properties have achieved pricing above early 2020 levels. Though some submarkets in some metros continue to contend with weakened fundamentals that are suppressing values, optimistic investors in many cases are underwriting a strong recovery in 2021. Non-premier housing will likely enjoy the most robust renter demand, but Class A properties will also see a leasing recovery as workplaces reopen. Lifted investor optimism is spurring acquisition demand, but current trends have also persuaded some prospective sellers to hold onto assets longer. Strong buyer interest has aligned with hesitant seller activity to bolster price appreciation and apply downward pressure to cap rates, with a current national average in the low-5 percent range.