Wednesday, December 14, 2016

Are We Near The Top?

We get this question every day. Investors are doing everything possible to figure out if this bull market is really long in the tooth or if it there is room to run before the next correction. No one knows the answer and there are as many opinions out there. As you might expect, we have some thoughts of our own on the subject, and we share them with you in this brief post in the hope that our perspective will give you a fresh way to look at this all-important question.

Let us say at the outset that timing market peaks is dangerous business. As the old saying goes: when timing your exit from an asset class, it doesn’t hurt to be a few hours early, but don’t be a minute late. When it comes to the real estate business, it’s probably measured in months rather than days, but the results can be just as disastrous if your timing turns out to be bad. So, we take the question seriously and tend to look at it from a cautious perspective. Yes, we are here to help you make the most of your real estate investments, but we are also in the business of evaluating risk and preparing for the unexpected. 

So, where exactly are we when it comes to this real estate up-cycle from a pricing point of view?________________________________________________________________________

The answer to that varies substantially depending on product type. Office sales prices are still slightly below the previous peak, but multi-family and retail product is substantially above the previous peak in 2006-2007. Without anything else figured in, the logical conclusion is that office properties have more upside potential than retail or multi-family. But, when other variables are factored in, the picture becomes more opaque. 

The reality is that each product type and each market are influenced by a variety of value-changing conditions. Take multi-family product as a prime example. Rents in gentrifying areas throughout San Diego County have risen the fastest, driving cap rates to historic lows and price per square foot to an all-time high. The millennials who rent in these areas have a different lifestyle and have different ideas about home ownership, cars, food, recreation and overall lifestyle. Quite simply, they live in a different world with different priorities than the preceding generation. As a result, they will pay more for location, convenience and proximity to the amenities of their choice. That has been a major contributor to rapidly rising multifamily rents and the resulting compression in cap rates. 

Does that mean the multifamily market is near a natural peak because it has seen the most appreciation? Not necessarily. However, rock-bottom interest rates that have resulted from US Federal Reserve Bank’s monetary policy have also given multi-family pricing a boost of its own. Cheap money has expanded the pool of active buyers and sent demand soaring. So, there is some logic to the assumption that cap rates will move in the other direction when the Fed reverses its current course.

So, no one knows for sure if the multi-family market is long in the tooth, but apartment property owners with a shorter term investment strategy may be wise to dispose of assets sooner rather than later. Investors who have the time and patience to ride out another cycle may decide that it is best to enjoy the benefits of high rents and low vacancy for years to come.

The office investment market has also moved much higher, but is still below the previous market peak. Rents have grown substantially since the recession ended, but vacancy remains high enough to keep a more even balance between tenants and their landlords than in the multi-family market. Local entrepreneurial companies are leveraging new communication technologies and workplace designs to use less space when they relocate. Cloud-computing, wireless networks, smartphones, laptops and tablets all allow for the free movement of workers both inside and outside the office. This has resulted in lower net absorption and that, in turn, is keeping rent growth in check. However, older, well-located buildings are being re-purposed by add-value buyers to meet the growing demand for creative space designs that command higher rental rates. Even traditional office users like those in the legal services sector are embracing this trend, but are doing so, in part, to occupy less overall space. Ground-up development of office space is nominal, and high land prices along with rising construction costs will keep construction near current levels moving forward. So, the market is unlikely to experience overbuilding as it did before the Great Recession began. 

Office building owner with the resources to reposition their assets to meet current trends will see the best rent growth.

Those who do not, may see net operating income flatten out and values decline if cap rates move off their historic lows.

Should you sell your San Diego investment property soon? The answer to that question depends on your unique circumstances, including but not limited to your tolerance for risk, willingness to realize a taxable event and your long term portfolio strategy. As commercial property experts, we stand ready to assist you in any way possible to help you make the most informed decisions possible.