Morgan Stanley analysts last week predicted U.S. commercial real estate prices would grow by a big fat zero percent in 2016, replacing a previous forecast of 5 percent growth over the course of the year.
It was a surprising prediction for a market which has seen prices easily blow past their pre-financial crisis highs. Values for office buildings, hotels, shopping malls and the like have appreciated rapidly in recent years, thanks in part to insatiable investor demand for higher-yield commercial real estate assets.
In a Q&A published on Tuesday, Morgan Stanley analysts led by commercial real estate veteran Richard Hill further explain their decision, citing a worrying dynamic between lenders and property values.
CRE investors typically target a specific levered return profile when buying into the asset class. If leverage goes down, by dint of falling property prices that result in lower loan-to-value ratios, they need something else to increase in order to offset it.
"We recognize the very important role that the lending markets have played in the recovery in CRE prices," the analysts write. "Indeed, our analysis shows that a 10 percentage point decline in the loan-to-value ratio (from 70 percent to 60 percent ) requires 2.25 percent annual net operating income growth to offset the lower leverage."
In other words, the income generated from the properties would need to rise in order to keep investors happy and help them maintain their returns. That's a hurdle that may prove difficult to reach in an environment of slowing corporate earnings and even a potential recession.
Throw in higher financing costs—U.S. financial conditions have already tightened following the Federal Reserve's decision to raise interest rates back in December—and required income needs to increase even more.
Morgan Stanley's flat growth forecast conceals a possible bifurcation between high and low-quality commercial properties, as well as a potential division dependent on funding sources.
The portion of commercial real estate funded by commercial mortgage-backed bonds, known as CMBS, has fallen to about a fifth of the overall market as of last year, but still remains historically high for certain segments. Sales of CMBS have slowed in recent months thanks to the slump in oil casting doubt on some property values as well as new rules intended to strengthen the market.