Bullish Outlook
An Analysis of Capital Market Conditions and Trends
By Paul Fiorilla
Investor capital is pouring into commercial real estate, especially favored segments such as multifamily, industrial, single-family rentals, and self-storage.
Capital market conditions entering 2022 are nearly optimal, with the sector gorged with debt and equity as investors seek to deploy capital in a sector with strong fundamentals and bullish prospects in coming years. Plus, borrowers seek to take advantage of rock-bottom interest rates. Added together it has produced record-high deal flow and rock-bottom acquisition yields, even as Treasury yields rise.
The story is the same on the debt side. “Every capital source has a really strong appetite for placing mortgage debt this year,” says Jamie Woodwell, vice president of research and economics for the Mortgage Bankers Association.
Activity is driven by the flood of capital into commercial real estate, as investors are looking for stable assets with potential for appreciation. That leads them to alternative sectors including real estate, which provide steady cash flow and higher yields than fixed-income sectors such as sovereign debt or investment-grade corporate bonds.
In late 2021, more than 1,000 private equity funds alone targeted more than $350 billion of U.S. real estate investments and were sitting on upwards of $250 billion of dry powder, according to Preqin, a London-based data and analytics firm that tracks global investment trends. Most private equity dry powder involves funds seeking opportunistic (30%), value added (28%) or debt (22%) investments. With that much capital looking to be deployed, the biggest limit to deal flow is how many sellers are willing to put properties on the market.
Property sales hit record highs in 2021 while yields, or cap rates, declined in every property sector. Total commercial real estate transaction volume shattered records in 2021, according to Real Capital Analytics (RCA), which tracked $808 billion of deal flow, up 88% over 2020.
Sales Hit Record Levels
Within real estate, multifamily and industrial are the main targets for investors among the traditional major asset classes. More than 60% of property sales last year were in those two property sectors, per RCA. Apartment sales totaled $335.1 billion, up 128% year-over-year, while industrial sales totaled $166.3 billion, up 56% from 2020, according to RCA.
As those segments get crowded with buyers, yields get squeezed. In 2021, apartment cap rates fell 50 basis points to an average 4.5%, while industrial cap rates declined by 30 basis points to 5.5%, per RCA. Yields in both sectors are at all-time lows.
The difficulty in winning competitive bids and the desire for higher returns has led some investors to branch out into niche property types including self-storage and single-family rentals. Some $10.9 billion of self-storage properties traded during 2021, a 161% increase over the $4.2 billion sold in 2020, and well above the previous high of $4.3 billion in 2016, according to Yardi Matrix. New York City led the activity at $3.2 billion, most of which was StorageMart’s acquisition of a portfolio owned by Edison Properties. Institutional and private equity capital are focused on portfolio purchases to deploy large amounts of capital quickly.
Investment in single-family rentals (SFRs) also surged, although the dynamics are different because of the nature of the product. Institutions have raised more than $10 billion to invest in SFRs. Some are acquiring assets by buying houses one at a time. Acquisitions of SFR communities with 50 or more units increased by more than three-fold in 2021, to $171 million from $52 million in 2020, according to Yardi Matrix. Other institutions have a build-to-rent strategy that involves developing communities of single-family homes or townhouses to rent. Yardi tracks 38,000 SFR units in the development pipeline, with 17,000 units in SFR communities currently under construction, mostly in the Southeast, Southwest, and Midwest.
One attraction for investors is the rapidly rising rents in the self-storage and SFR segments. Self-storage street rates rose about 7.5% year-over-year in 2021, per Matrix, as demand boomed during the pandemic. The ability to work from home and vibrant housing market have helped to foment migration and increased the use of self-storage for home offices and gyms. What’s more, an increasing number of businesses are using larger storage units for distribution and logistics facilities.
Single-family asking rents continue to be a bright spot on the investment horizon, growing by 13.5% nationally year-over-year through January 2021, per Matrix. Demand remains strong, driven by households that want more space and amenities such as yards for pets and for small children to play. John Burns Real Estate Consulting reports that upwards of $50 billion of capital is competing for SFR investments. Although that sounds like a great deal of money, Burns estimates that it amounts to about 125,000 homes, or roughly 1% of the SFR market. Still, the variety of investor types, which includes large institutions and foreign capital, and the diversity of equity and debt strategies involved is a good sign of a developing market.
Lending Boom
Market conditions also drew capital to the debt markets in 2021. Securitization volume reached post-2007 highs in 2021. CMBS issuance of $110.5 billion was the highest since 2007, while CLO issuance reached a record $45.4 billion, per Commercial Mortgage Alert (CMA). CLO issuance was fueled by the growth in debt fund vehicles and demand for loans on value-add multifamily properties that are looking for short-term debt. Almost 70% of CLO issuance ($31.7 billion) was backed by multifamily assets.
Freddie Mac estimated that multifamily lending totaled $450 billion in 2021, up from $360 billion in 2020. Multifamily origination included a record $129.7 billion securitized by Freddie and fellow government-sponsored enterprise (GSE) Fannie Mae, according to CMA.
The biggest development in recent years, however, has been the rise of private equity debt funds. Upwards of 200 debt funds are operating and/or raising money as investors look for alternate ways to put capital to work in commercial real estate. To some degree funds have helped to fill in the void of transitional property lending that was created after the Global Financial Crisis when investment banks such as Lehman Brothers and Bear Stearns crashed, high-volume shops such as GE Capital left the market, and money center banks became more conservative as regulators kept a more watchful eye on risk.
Private lenders that focus on high-yield debt have dotted the CRE landscape for many years, but performance tends to be volatile in down cycles. Proponents, however, say that today’s funds are on more solid ground. For one thing, many of today’s funds are better capitalized with lower leverage than in the past while avoiding volatile funding instruments such as repo facilities. Some are making use of technology such as CLOs to shed risk.
“Sponsors are now viewing non-bank lending in a more conventional manner,” says Adam Tantleff, a managing principal at Madison Realty Capital, which closed a $2.1 billion debt fund last year and has completed $20 billion of primarily debt-related transactions over the last 17 years. “Sponsors are more focused on the solutions provided by the originator and less focused on the cost.”
Impact of Rising Rates
The investment boom is taking place amid historically low interest rates. Interest rates are set to rise in the next 18-24 months as the Federal Reserve attempts to rein in inflation. Economists expect the Fed to increase policy rates by 100 basis points or more in 2022 and could push them up more if that fails to bring inflation back to its targeted level of around 2%.
Property values are at new highs. RCA’s commercial property price index (CPPI) rose by 22.9% in 2021. The CPI was led by increases of 29.2% for industrial and 23.6% for apartments, but all major sectors increased by at least 14%. The rapid growth, intense competition for deals, and almost unbridled optimism leads to questions about whether the market is getting overheated. Some of the same dynamics occurred in the run-up to the 2008 financial crisis, unleashing a wave of delinquencies starting in 2008.
Is it different this time around? There are some parallels to past cycles when rapid growth preceded downturns. Market players note, however, that there are also important differences that support the more optimistic outlook, starting with the fact that higher loan proceeds are grounded in higher property income and not pro-forma underwriting. For example, U.S. multifamily asking rents increased an unprecedented 13.5% in 2021 and are projected to rise at above-trend levels in 2022, according to Yardi Matrix. Another example: same-store industrial properties have recorded an average annual 4.7% increase in net operating income over the last decade, per RCA.
What’s more, unlike 2008, when the country became mired in a recession, the economy is expected to record growth in the 3-4% range over the next two years, with optimism owing to factors such as healthy consumer balance sheets and the strong job market. The biggest economic headwind is inflation, and commercial real estate has historically performed well during times of high inflation.
“Inflation is not going away any time soon. Commercial real estate investment has always been an attractive vehicle to counter inflation’s drag on macro investment valuations,” said Lisa Pendergast, CREFC executive director. “Continued sound underwriting, and reasonable leverage are supportive of the sector’s ability to provide an inflation hedge.”
