Despite Global and Domestic Headwinds, U.S. Commercial Markets on Firm Ground in 2016

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According to the National Association of Realtors most recent Q2, 2016 Commercial Real Estate Forecast, buoyed by a steadily improving labor market and strong demand for multifamily housing, U.S. commercial real estate activity should remain on an upward trajectory, with a growing share of it is expected to be in smaller markets.

National office vacancy rates are forecast by Realtors to fall 1.5 percent to 10.4 percent over the coming year as employment gains boost demand for office space. The vacancy rate for industrial space is expected to decline 0.7 percent to 8.7 percent, and retail availability to decrease 1.0 percent to 10.5 percent. Only vacancies in the multifamily sector are expected to edge higher over the next year, from 5.9 percent to 6.1 percent, as new apartment construction comes onto the market.

Lawrence Yun, NAR chief economist, says the commercial real estate sector is on firm ground in spite of the numerous global and domestic headwinds that continue to keep U.S. economic growth in a headlock. "Ongoing overseas weakness and the slowdown in business investment despite historically low interest rates held second quarter growth at a tepid and disappointing pace," he said. "Only steady job creation, solid consumer spending and residential construction - albeit not enough of it - kept the economy afloat during the first half of the year."

Adds Yun, "Tightening vacancy rates and rising rents are clear positive fundamentals, but commercial real estate property prices have been bid up too high and look to weaken in the upcoming months."

Strengthening local job markets has fueled sustained demand for commercial space and has pushed vacancy rates down in all commercial sectors. However, a growing concern from Realtors, who mostly have clients that rely on financing to secure deals, is that underwriting standards have stiffened in light of increased regulatory scrutiny.

"Any further tightening in credit standards, which never fully normalized after the recession, would inflict the most pressure on the small and mid-sized businesses that mostly look to community banks and credit unions for commercial property financing," adds Yun. "Not having the necessary access to capital could keep a lid on building and leasing activity and in turn keep the economy from getting closer to its long-term average of 3 percent growth."

With new construction outside of the multifamily sector taking a breather during the first half of the year, overall demand outpaced supply and suppressed inventory levels in many areas. This was evident in the Realtor's survey. The survey revealed that inventory shortages are the number one concern for Realtors, which is in turn pushing price growth upward. Prices for commercial properties increased 5.3 percent in the second quarter compared to a year ago, with the average transaction cost at $1.4 million.

"While inventory constraints and strong appreciation in apartment and retail properties pushed up prices in large commercial markets last quarter, overall sales volume was still down as investors looked for better deals and higher yields in smaller cities," says Yun. "As a result, investments and leasing activity in middle-tier and smaller markets led the way and are expected to maintain their momentum in coming months."

Given the global low yield environment, instability overseas and the probability of a rate hike by Federal Reserve at the end of the year, investors are expected to take a cautious approach in the months ahead, leading to a likely slowdown in commercial property prices - especially in Class A assets in larger markets. Meanwhile, prices in smaller markets should continue to climb with strong tenant demand and declining supply supporting growth.

According to Yun, the demand for apartments will continue to drive multifamily housing construction, albeit at a more moderate pace, as a growing share of builders shift from apartments to single-family homes. Expected completions being added in coming years should begin to moderate rents and nudge vacancies higher.

"The U.S. economy has its flaws and has been stuck in slow-growth mode ever since the Great Recession," says Yun. "However, it's still the top performing economy in the world, and U.S. commercial real estate should continue to remain a stable investment and attractive option for investors even as rates move upward."

NAR's Commercial Real Estate Outlook offers overall projections for four major commercial sectors and analyzes quarterly data in the office, industrial, retail and multifamily markets.