Commercial-property buyers may shift their focus back to big coastal cities in the U.S. as persistent economic weakness and Europe’s sovereign-debt crisis prompt a retreat to the safest investments.
Investors have been moving into secondary markets such as Dallas and Minneapolis amid growing confidence in the recovery and soaring prices that drove down yields on office buildings, shopping malls and apartments in prime cities including New York, San Francisco and Washington.
The trend may be cut short. Turmoil in financial markets over the past three weeks -- triggered by concern that Spain and Italy will struggle to pay off their debts, signs that the U.S. will remain mired in sluggish growth through next year and Standard & Poor’s downgrade of the U.S. credit rating -- may send buyers back to prime cities and push prices even higher, as long as the economy doesn’t deteriorate so much that trophy properties suffer.
“In this market volatility, it’s no surprise that investors, commercial real estate investors, are rotating toward less risky types of investments, which are core properties in primary markets,” Asieh Mansour, head of Americas research for property firm CB Richard Ellis Group Inc. (CBG) in Los Angeles, said in a telephone interview. “Investors across all asset classes do become more risk averse.”
On each of the first four days of last week, the S&P 500 Index (SPX), a benchmark for the biggest U.S. stocks, rose or fell by more than 4 percent, an unprecedented streak of volatility, according to data compiled by Birinyi Associates Inc., Bloomberg and Howard Silverblatt, senior index analyst at S&P.
Meanwhile, the U.S. sold $32 billion of three-year notes on Aug. 9 at a yield of 0.5 percent, the lowest since records began in May 1981, as investors sought shelter in the relative safety of government debt. Gold, another haven, gained 5.5 percent last week as it touched a record $1,817.60 an ounce, before retreating to close at $1,742.60.
“This volatility in the stock market could be a boon for commercial real estate as long as the demand doesn’t fall off too much on the economic side,” said Christopher Macke, senior real estate strategist for CoStar Group Inc. (CSGP), a Washington-based property-data company. “I would not be surprised to see the pricing in core assets improve.”
Purchases of commercial properties in secondary markets had been increasing this year, extending a rebound that started in the big coastal areas. Transactions rose more than sixfold in Las Vegas in the first half of the year from the same period in 2010, according to Real Capital Analytics Inc. Deal volume rose 253 percent in Phoenix, 204 percent in Atlanta and 267 percent in Pittsburgh over the same period, while sales gained 151 percent in Manhattan and 71 percent in Washington, data from the New York-based property-research firm show.
Premier office buildings in cities such as Washington and San Francisco, regional malls across the nation and apartment buildings on the coasts may get a boost from investors wanting stable cash flows from the best properties after the S&P downgrade, Alexander Goldfarb, an analyst at Sandler O’Neill & Partners LP in New York, said in a telephone interview. The most attractive buildings have a high proportion of long-term tenants with good credit.
Investments in properties with lower occupancy rates in smaller cities may see demand slump as investors view them as riskier, CoStar’s Macke said. Building values and rental rates don’t appreciate as fast in secondary markets compared with land-constrained coastal markets because it is easier to construct new buildings.
Big City Risks
“Capital in real estate will continue to seek quality, quality of location and quality of product,” said Jim Sullivan, manager of North American real estate investment trust research at Green Street Advisors Inc. in Newport Beach, California. “Whenever everyone piles into the same investment, it drives prices up, sometimes further than they should.”
The New York and San Francisco property markets can be volatile and aren’t without risk, Sullivan said, pointing to the plunge in values in Manhattan during the financial crisis and in San Francisco when the Internet stocks crashed. New York metropolitan office prices fell 41 percent from the peak in 2008 to the 2009 bottom, according to Moody’s Investors Service.
“They sure haven’t proven to be safe havens,” Sullivan said.
U.S. gross domestic product expanded at a 1.3 percent annual rate in the second quarter, after a 0.4 percent pace in the prior period, the worst six months since the recovery began in June 2009, Commerce Department figures showed July 29. The unemployment rate in July was 9.1 percent, the fourth straight month it was 9 percent or higher.
If the Fed is successful, prime and secondary commercial real estate markets should benefit.
“We are in an economic recovery, although subdued in the near term,” said Mansour of CB Richard Ellis. “There will be investors who will eventually move up the risk-return spectrum and will consider the secondary markets.”
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