Portfolio Strategy

February 4, 2022

By the Numbers

A blowout December, moderating but sustainable prices for CRE

Mary Beth Fisher, PhD | February 4, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

December 2021 marked a banner month for commercial real estate transactions, and the momentum appears likely to continue into 2022. CRE property price growth across most sectors appears to be moderating after exceptional gains during the pandemic. Fundamentals remain positive for multifamily and industrial properties, while prices for office properties remain broadly subdued. The outlook for inflation remains an important consideration for investors, as some academic studies show real estate serves as an effective partial hedge against inflation.

Commercial real estate transactions surged in December.

Repeat sales transactions through most of last year had been running from 1,300 to 2,200 a month but jumped in December to 3,100 (Exhibit 1). December is typically a heavy month for CRE sales, but the last two years the number of December transactions rose above the year’s monthly average by nearly 50%. Sales activity slowed markedly during the early months of the pandemic in 2020, from about 1,500 a month to well below 1,000. By September of 2020 CRE transactions increased back above 1,300 and continued surging higher. In the second half of 2021 there were about 2,200 sales a month with a jump in December to 3,100. The increase in sales was across both investment grade and general CRE properties. Of the $35 billion in CRE transactions in December 2021, $25 billion was for investment grade properties, as defined by CoStar.

Exhibit 1: CRE transaction history

Note: Monthly data through December 2021.
Source: CoStar

Distressed sales have remained depressed both outright and as a share of CRE transactions

What has not yet materialized is a significant increase in distressed sales due to the pandemic. Distressed sales hit an all-time low as percentage of transactions in December of 1.16% (Exhibit 2, left-hand graph) but this is partly due to the surge in overall activity. The number of distressed sales (Exhibit 2, right-hand graph) ticked up modestly from about 35 to 45 a month in the third quarter of 2021, before declining back to the low 30s, where it’s been since 2017. Distressed sales are almost certain to rise in 2022, but strong CRE property price appreciation will likely limit the number of sales to well below the recent peaks seen in 2010 to 2014.

Exhibit 2: CRE transactions that are distressed sales

Note: Monthly data through December 2021.
Source: CoStar

The pandemic-fueled growth in CRE property prices is showing signs of moderation

Property price increases began to decelerate for multifamily in the second half of 2021 (Exhibit 3, left-hand graph). Multifamily property prices rose by 5.9% quarter-over-quarter in 2Q of 2021, a recent peak, before moderating to a 3.8% increase in the third quarter and slowing further to up 2.0% in the fourth quarter of 2021. That still leaves multifamily properties up 15.6% for the calendar year of 2021, and up 27.3% compared to pre-pandemic levels. That is the strongest price appreciation through the pandemic of any major property type (industrial +26.4%, land +19.2%, retail +17.3%, office +13.5%, hospitality +0.4% from pre-pandemic).

Exhibit 3: CRE prices by property type

Note: Equal weighted indices, quarterly data. Data through December 2021.
Source: CoStar

A considerable amount of agency CMBS prepayment activity during the pandemic was driven in part by borrowers taking out equity thanks to the rapid rise in property prices. As that moderates and rates rise, prepayment activity should fall rapidly. The recent rise in conduit CMBS, CRE CLOs and SASB issuance could stay elevated through the first half of 2022 as CRE transaction activity remains strong.

Have real estate prices crossed into bubble territory?

It’s a reasonable question to ask if real estate prices reflect a bubble, but so far the price increases appear definitively related to mismatches between economic and demographic factors driving supply and demand – not artificial demand created by low interest rates and easy credit standards. For example, the decade-long rise in multifamily property prices before to the pandemic is due to a dramatic drop in home building activity, which crimped supply, despite growing demand from millennials seeking to form new households. The pandemic-fueled surge in demand for housing has so far returned single-family and multifamily home building to reasonable levels. The increase in home construction will still require close to a decade to close the gap based on a decade of underbuilding and a projected long-term shift towards more renter than homeowner households.

The rise in industrial property prices can be summed up in a few words: Amazon, Fed Ex and shipping. The shift in delivery models and consumer migration towards more online shopping is likely permanent, even if it comes off the pandemic high. Depending on how sticky the remote working trend is, prices for office properties in dense, very expensive metro areas such as New York and San Francisco could be subdued for years.

It is possible that the specter of long-term inflation could be luring more investors into real estate, temporarily putting upward pressure on prices. There is a substantial body of academic and financial market research that attempts to determine which asset classes are good hedges against inflation. The primary asset classes evaluated include common stocks, gold, fixed income securities and real estate. The research studies date back to 1930 and the data, methods and results across most asset classes are somewhat inconsistent to, in some instances, wildly conflicting. This will be a topic of a future strategy missive, but here are some boiled down conclusions:

  • The asset that provides the best hedge against inflation – meaning the returns of the asset are positively correlated to inflation – are inflation-linked securities
  • The next best asset may be real estate, but with a few caveats:
    • Real estate appears to hedge inflation best over long periods of time, though at best it provides a partial hedge
    • Direct real estate holdings may work better than indirect holdings in publicly traded REITs, though there are conflicting studies which are sensitive to the time period chosen for evaluation and the sophistication of the regression model being used
    • Real estate probably hedges expected inflation better than unexpected inflation, though that seems to be true of most asset classes with the exception of inflation-linked securities.

Long-term trends across regions

Property prices follow economic activity which follows migration of people. The Midwest has been losing people and businesses to the South and the coasts for a decade, and it shows in the broad underperformance of their real estate sector (Exhibit 4).

Exhibit 4: CRE prices by region

Note: Equal weighted indices, quarterly data. Data through December 2021.
Source: CoStar

The Northeast suffered the least overall depreciation after the housing crisis and continues to hold its own. However, the migration out of the northeast to the south and west has fueled outperformance for a decade, and that’s unlikely to turn around in the 2020s.

Mary Beth Fisher, PhD
1 (646) 776-7872
mfisher@apsec.com

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