MARKET INSIGHTS
January 4, 2018

Andy Little

BY ANDREW LITTLE, Special correspondent, 

David Lee Roth could have been referring to commercial real estate exposure when he crooned “Everybody Wants Some!!” in Van Halen’s 1980 hit song.

Many investors fear inflation and think real estate is a good hedge against its corrosive influence on buying power.

That thought has pushed yields on commercial real estate to all-time lows and has made pricing on many assets reach nose-bleed territory.

While overall investment sales volume nationally has fallen since its peak in 2015, prices have remained strong.

Year-to-date sales volume through the third quarter is down about $24.7 billion compared with the same period in 2016, which was down about $23.4 billion from 2015, according to data from Real Capital Analytics, a New York-based real estate research firm.

With renewed confidence in the economy and tax reform on the horizon, fourth-quarter expectations are high that the trend will reverse itself, but ultimately volume is not likely to surpass 2016.

Regardless of volume, pricing continues to rise, particularly for apartments and industrial properties.

The category weighing down additional price gains is malls. This trend is expected to continue into 2018 as more investors are trying to get exposure to real estate.

The category weighing down additional price gains is malls. This trend is expected to continue into 2018 as more investors are trying to get exposure to real estate.

A recent Wall Street Journal article highlighted commercial real estate investing for nonprofessionals demonstrating the asset class’s importance to a well-rounded portfolio.

The article concluded by recommending that investors should be wary of price appreciation in real estate and focus on cash flow, senior housing, demand for new housing and perhaps experiential retail.

Against a backdrop of inflation fears, the Republican-led Congress has whisked through the largest tax reform bill in recent memory that is sure to bring stimulus to a fairly hot economy. The Tax Cut and Jobs Act comes at a time when unemployment levels are at 16-year lows and monthly employment numbers are actually quite good.

For now, inflation has remained in check as wage growth hasn’t really kicked in, and that has helped keep interest rates low.

Rates are about where they were last month and are currently in the 3.6 to 3.85 percent range for 5- and 10-year loans offered by life insurance companies, according to the John B. Levy National Mortgage Survey. Conduit pricing has come in dramatically and now averages 4.10 to 4.35 percent for higher leverage loans.

The final version of the tax reform bill brings comfort to an anxious and confused real estate community. Bedrock issues for investors like deductibility of interest on investment properties and depreciation were largely left alone.

Niche businesses in the real estate world also fared well. Businesses that thrive on like-kind 1031 real estate exchanges were left untouched and historic tax credits were changed but not eliminated as was suggested in an earlier House version of the bill.

The other beneficiaries in real estate are fund operators that will continue to be taxed at the lower capital gains tax rate for their carried interest.

The bill moved very quickly and it is safe to say that these changes are the most wide-sweeping and ambitious tax reforms since the Tax Reform Act of 1986. Let’s hope the results are not as disastrous to the real estate industry.

Continued low interest rates, an economy that is growing, and stimulus on the way in the form of tax reductions has created an environment that is healthy for real estate transactions and, increasingly, deals seem to be priced to perfection.

Unlike in 2007 when peak pricing was fueled by ridiculous debt underwriting, equity is abundant today.

As in other cycles, when pricing gets too high in larger cities, smaller cities look attractive and money pours in.

That trend is what the Richmond region experienced in 2017, and it should continue into 2018. Excitement in the area is palpable as notable projects are taking shape all over the region.

The downtown skyline will be forever changed as the new Dominion Energy headquarters building races toward completion.

GreenGate in the Short Pump area is continuing a trend started with West Broad Village showing there is plenty of demand for mixed-use development that has for-sale residential adjacent to restaurants and shopping.

Work on the redevelopment of Regency mall continues, and the roster of tenants that are stepping up makes that the definition of experiential retail.

Midrise apartments in Scott’s Addition and at the Reynolds South site in Manchester as well as in the Midlothian suburbs and far western Henrico County add to the vibe that make the Richmond region’s commercial real estate exciting in 2018.

John B. Levy & Co. partner and investment banker Andrew Little can be reached at alittle@jblevyco.com.