U.S. Real Estate
Deal flow accelerated alongside year-end dynamics, but commercial property transactions declined 28% year-over-year in the first quarter, as economic uncertainty continued to suppress the transaction market. The lack of entity-level deals, specifically in industrial, was also a drag in comparison to the first quarter of 2020. Property sales activity continues to be bifurcated, with property types that have been less impacted by the pandemic on a relative basis—such as industrial and multifamily—experiencing lower declines than lodging, office, and retail. The largest declines were seen in the retail sector (down 42%), followed by industrial (down 41%), then office (down 36%), hotels (down 21%, excluding a large portfolio transaction), and apartments (down 12%). Major gateway markets and central business districts are typically a driver of transaction volumes; however, despite some emerging green shoots, investors remain tentative about the outlook for urban areas and the magnitude at which households and companies are considering and moving to more affordable Sun Belt and secondary markets.
The Trepp CMBS delinquency rate stood at 6.58% in March, down from 7.81% in December and a peak of 10.3% in June. Although the rate declined materially due to loan modifications and rent abatements, which have reduced distress, maturity-related defaults are likely to persist. Loans with a special servicer decreased to 9.39%, the sixth consecutive monthly decline. Meanwhile, 24.2% of lodging loans remain in special servicing, less than 1% off the peak. Lenders have largely accommodated defaults by providing forbearance measures; however, such cooperation has intermittently waned, and recapitalizations and forced sales have ensued.
Real estate markets are not yet out of the woods, but some of the worst outcomes were not realized thanks to the unprecedented and coordinated central bank and fiscal policy response. With COVID-19 vaccinations providing a path to recovery, investors have taken advantage of significantly reduced borrowing costs. The Federal Reserve Board has maintained its low-rate stance and willingness to tolerate the potential for increased inflation. However, as economic indicators continue to track a sawtooth path higher, longer-term interest rates have risen off the lows, compressing the spread to cap rates.
On the valuation front, the Green Street Commercial Property Price Index—which is still approximately 5% below pre-pandemic levels—increased 2.6% in the first quarter, but with significant variation by property type. A continued rally in U.S. REIT shares has been instigated by ongoing liquidity, sustained stimulus, vaccine penetration yielding a reorientation of behaviors, and the prospect of a full reopening seemingly being in sight. Company valuations now imply improvement in private market property valuations. Listed REITs in core sectors ended the quarter at a premium to NAV of 5%. Green Street Advisors’ model, which tracks the relative value relationship between private real estate and fixed income (investment grade and high yield), pegged real estate at 17% undervalued.
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Private real estate pricing has begun to correct, but with significant variation by property type. Note, the Moody’s CPPI Index reflects an upwards bias due to activity in property types that have been less impacted on a relative basis (e.g., industrial and multifamily).
Core property type valuations for U.S. REITs imply a recovery is expected in private market valuations as a whole, with variation by property types. However, the public markets are also signaling that U.S. REIT balance sheets are in good shape and well positioned to be acquisitive.
Unlevered real estate has historically offered a return between investment grade and high yield bonds. Real estate currently appears significantly undervalued on a relative basis compared to debt.
The combination of development deliveries and a demand shock is driving rent and occupancy declines; however, a recovery is underway for most property types.
New deliveries are generally at cycle peak and are expected to decline. Apartments, industrial, and storage are notable exceptions.