We've frequently written about the growing supply problem in the major commercial real estate markets across the country (for example: NYC Commercial Real Estate Sales Plunge Over 50% As Owners Lever Up In The Absence Of Buyers). Now it seems that Moody's is also growing somewhat concerned that growing supply, combined with waning demand and bubbly valuations, is a toxic combination for commercial office real estate projects and could result in disastrous consequences for the CMBS market. Here are the highlights from Moody's:
Referring to business cycles, the stock investor Sir John Templeton once said that the four most dangerous words investors say are “this time it's different.” This axiom applies to the current US commercial mortgage backed securities (CMBS) market as the commercial real estate (CRE) cycle is on the verge of another tipping point, and some market participants are hoping that this cycle will be different. Issuers are aggressively underwriting loans to peaking property values and cash flows, while new office construction is ramping up in a number of major cities. Supply is set to exceed demand in many cases, a credit negative for office-backed CMBS.
» Late-cycle supply-demand imbalances and aggressive underwriting weaken credit quality of CMBS office issuance. Underwritten office property values far surpass those of the pre-financial crisis peak, especially for central business district (CBD) offices, while many US cities are set to have an oversupply of new office inventory. Over the last 12 months, office properties backing new issue conduit/fusion CMBS received our highest value haircuts of any major property type, averaging 53% for CBD offices and 48% for suburban offices.
» The imbalance caused by new construction and softening economic demand mirrors the inflection points of previous cycles. Through 2018, we expect the annual growth rate of US office space to roughly double that of the last three years. Meanwhile, the 2018 growth rate of office-using employment will decelerate by about half that of 2017. As supply exceeds demand, the overall office vacancy rate will likely climb more than 1.5 percentage points over the next three years from the current cyclical low of about 13%.
» Clear signs of a momentum shift in the largest CBD office markets. San Francisco and Seattle are the two largest supply-demand imbalanced CBD office markets, and both have vacancy rates likely to double in the next three years to over 12%. Vacancy rates of the four other largest markets will rise 1%-2% over the same period. Additionally, cap rates have been rising in these six markets, signaling a cyclical inflection point in the CRE capital markets as well as in the CRE space market.
» Many suburban office markets have equal or greater risk of oversupply. Three suburban office markets with significant upcoming supply-demand imbalance are San Francisco, Austin and San Jose, each driven by the latest technology industry boom. Further, in some cases, such as CBD San Francisco and Oakland, downtown building booms have spilled over to surrounding “fringe” submarkets with transformative effects.
Of course, as we've noted numerous times before, it's not difficult to understand why Moody's is concerned with where we are in the commercial real estate cycle. Here's a quick primer...perpetually low interest rates from the Fed has caused a massive bubble to form in the valuations of commercial real estate projects as cap rates have trended ever lower over the past several years. These lucrative valuations have resulted in a flood of new supply...
...just as demand is waning...
...resulting in surging vacancy rates.
It all adds up to a very consistent commercial real estate cycle which Moody's figures we're in the later innings of and could result in some pain for CMBS investors in the near future.
As numbered in the exhibit, the property market cycle has five key stages:
1. The economy recovers from a down cycle, businesses open and expand, and employment levels and tenant demand for space grow.
2. Vacancy rates decline and rents rise as the economy expands because CRE supply is inelastic and generally slow to respond to increased demand for space.
3. Rents rise and cap rates compress to the point where property values exceed the cost of construction including builder's profit. New construction ramps up. Because of CRE market inefficiencies such as developers' overly optimistic expectations of future demand and long delivery times of large building projects, supply of new CRE space tends to overshoot that of demand.
4. The broader economy peaks and market corrections spur an economic contraction period. Demand for space recedes while multiyear construction projects are still underway and delivering new supply into a waning market.
5. The imbalance of supply and demand causes vacancy to spike. Property values fall, as landlords accept lower rents and skittish investors demand higher risk premiums in cap rates in the uncertainty of a downturn.
With that, here's a list of which markets are most at risk of oversupply...not surprisingly several markets on the west coast that cater to the tech industry are most overheated...
...and here's a list of which cities are currently in the process of making their problems even worse by adding new capacity to already oversupplied markets.
But this time is probably different...