Multifamily and industrial property values continued to show strong gains in the fourth quarter, while the outlook for the retail and office sectors ticked up, according to SitusAMC Insights’ new quarterly report, Current Valuation Insights. Our analysis leverages the boots-on-the-ground perspective of SitusAMC’s current appraisal and valuation management work, offering investors real-time market and property-type insights ahead of many traditional commercial real estate (CRE) data sources.
Bifurcation Characterizes Apartment Market
The apartment market is in the midst of unprecedented increases in value. But the growth is uneven, with a clear bifurcation. Garden apartments outperform everything, followed by suburban beating urban. High-growth, high-demand markets in Colorado, Arizona, Southern California, Texas, North Carolina, Georgia and Florida are outpacing others. This bifurcation shows the importance of portfolio allocations in this segment.
The third quarter of 2021 marked the first time that positive momentum appeared in some gateway markets since before the pandemic. New York enjoyed strong occupancy starting in the first quarter, in the high 90% range, but it came at the expense of market rents. Now, New York City is finally starting to see a material recovery in rents. San Francisco is similar; occupancy increased in the beginning in the first quarter, but growth came at the expense of rents. However, the long-term viability of San Francisco is favorable and being factored into underwriting. Meanwhile, Chicago has seen a pullback in concessions even if rents have not actually increased yet.
Positive lease trade-outs are incredibly strong, especially for garden assets and in high-growth markets. The potential for some pullback in positive lease trade-outs is still unclear, and the pace of rent growth has cooled somewhat over the past couple of months. Still, one-year projections call for little difference between market rents and contract rents.
Rent growth is also especially prevalent in Class A- and Class B assets, where there is more room to grow. Investors are willing to accept lower overall returns because so much capital is available. In some instances, Class B properties are being valued at the same price per unit as Class A- assets.
Investors should keep an eye on rising expenses. Insurance costs are expected to increase 10% to 15% in 2022 and could continue climbing rapidly in subsequent years. Payroll costs are escalating as well, which will affect costs for repairs and maintenance. Taxes pose another area of concern. For example, in Cook County, IL, some properties are being assessed at 50% or even 100% higher than previously. Expense inflation would clearly have a negative effect on values.
Rent Growth Drives Industrial Values
Industrial offers the same story of incredible growth as apartments, but it would not be surprising if fourth quarter 2021 returns surpass the third. Market rent growth, along with the astronomical increase in land prices, are the big story of the fourth quarter. Coastal market rents are hovering at peaks, but seem to keep going up. Often, brokers do not put out asking rents because there is no availability. Appraisers are factoring in rent growth as high as 8% in years one and two, compared to 3% to 6% in past years.
Rent growth is swelling and rates are compressing. In the coastal markets, including Southern California, Northern New Jersey, Miami and Seattle, going-in cap rates range from 3.25 to 3.5%, and terminal rates are generally sticking to about a 50-basis point premium on top of that. Outside the key coastal markets, the cap rates are slightly higher, up to 4%.
Investors appear unfazed by the ultra-low cap rates because on a risk-adjusted return basis, they remain favorable. Considered on a trailing basis, they are extremely low, but investors must account for the phenomenal rent growth. Also, cap rates are finding an equilibrium without the aggressive compression prevalent in the past few quarters.
More Investors Express Interest in Retail
The bleeding appears to have stopped in retail, and it is reasonable to expect the modest recovery in values to continue, led by the grocery-anchored space. This segment has been adversely affected by the myriad supply-chain issues. Retail transaction volume has been lacking, but more investors are expressing interest. Most transactions are occurring in the grocery subsegment, and it could lead to larger deals.
In malls, tenant sales are rebounding in the strongest markets, primarily in the Sun Belt, but it is difficult to determine its cause or whether it is sustainable. Many malls have worked through their collection issues even though vacancy remains elevated. Large Class A+ malls in good locations are performing well. Many of them probably have a luxury component, which blossomed throughout the pandemic. Jewelry stores in particular prospered.
Office Sees Uptick in Leasing Activity
Newer Class A trophy properties with longer-term leases comprise most trades in this sector, generally in thriving markets in Florida, Texas, Raleigh, NC, with some in Southern California. Leasing activity and short-term renewals are ticking up, but many question marks remain. Return-to-office plans keep getting pushed back, and the eventual space shifts that arise from hybrid work policies have investors uncertain about future occupancy. Opinions vary widely about how much space new and existing tenants desire. Overall, the sector has seen a flight to quality as companies look for amenities to entice workers back into the office.
Office valuations have been flat, but the outlook is somewhat more positive. Many Sun Belt markets returned to 3% growth, and Seattle and Southern California are showing some growth. Investors are also seeing improvement in New York City trophy assets and in San Francisco.
Market rents, for the most part, are holding relatively flat, although they are rising in Florida, Southern California and North Carolina. Several companies are setting up their first offices in South Florida, bolstering strong rents. Boston is holding steady as owners convert offices to life science properties, responding to strong demand. Texas is highly bifurcated with strong rents in Dallas but not Houston.
Rents are decreasing in troubled markets including Portland and Chicago. In New York, tenants are signing quite a few more leases for longer terms, but receiving rates below market-leasing assumptions.
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