Just a year ago, I submitted an article to the Banker & Tradesman with some ideas as to how the commercial real estate market would play out over the course of 2013. At the time, Mayor Thomas Menino had yet to announce his retirement, the 10-year Treasury wiggled around 1.8 percent, and Boston was one of a select few markets to be considered a safe bet by investors. To be sure, 2013 was a year of change for us and the rest of the country.
Some of the focal points in last year’s outlook played themselves out in an interesting way; let’s take a look:
Theme 1: Interest rates will creep up, but not enough to affect asset pricing or transaction volume.
TRUE. We actually saw the 10-year Treasury teeter between 1.8 and 2.0 percent, before dropping to 1.6 percent in May. After some comments by the Fed chairman about an imminent tapering program, fixed income markets freaked out, and the 10-year rate widened by 100 basis points in 6 weeks. However, the increase had little to no impact on core asset pricing. Why? In part, it was due to borrowers switching to shorter-term deals with lower index rates in order to maintain the same yields. For core product, there was simply too much equity capital chasing high quality deals to affect pricing, and investors were prepared to accept lower returns versus losing a deal.
Theme 2: Maturing loans will be refinanced with ample debt capital and an increase in CMBS.
TRUE. Over $13 billion of CMBS matured in 2013 nationwide, in addition to maturities from banks and other lenders. CMBS lenders originated about $86 billion in the U.S. last year, an increase of $38 billion from 2012, which was enough to refinance 2013 maturities three times over.
Theme 3: Development in the office and hotel sectors will help to balance the wave of apartment projects under construction.
TRUE (sort of). New development of office buildings finally began in 2013, following a series of mega-deals in the office sector, where some major old-line tenants signed large build-to-suit leases in Boston (see State Street, PWC, Goodwin Procter) and in Cambridge (Pfizer, Millennium). Boston Properties looks to be ready to start on Boylston Street as well. We saw new hotels break ground with CV Properties’ twin concepts in the Seaport, and more projects to come in Cambridge, the Back Bay and other neighborhoods. Three of the four development firms mentioned in last year’s article have broken ground on various deals outside the apartment sector.
Regulatory Burdens
However, greater Boston’s development outlook is in line with much of the U.S., which suggests that new supply is falling short of the historic trend line. Like it or not, speculative development helps keep the commercial real estate sector in a state of positive momentum. Judging by some very early indications, Mayor Martin Walsh appears to be in favor of new development and a progressive planning commission, which bodes well for Boston.
There is one very real risk to new development over the long haul, and that is the regulatory environment. With the introduction of Basel III guidelines and other controls around banks, the required reserves for construction loans will be substantially higher than loans on income-producing properties. This puts a governor on leverage that can be obtained to build a project, and adds overhead to the loan which is passed on to the borrower. Capital markets will need to find a solution for this, and it’s not in plain view.
So where are we headed in 2014? The data suggest that fundamentals are in a state of steady improvement, not only in the U.S., but across the world. A rising tide lifts all boats, so while Boston won’t be as much of a crowd favorite as it was last year, it is still very much a favorite, and job growth along with a booming innovation economy will continue to bring capital to our city in a very real way.
Foreign Capital: This is a very real phenomenon, and it will change the dynamics of the real estate investment market over the long term. Over the last year, Asian capital made direct investments (not through US-based funds) in 24 percent of all transactions in the U.S. Foreign banks doubled their market share of loan originations from 2012 to 2013. And guess what? They all love Boston for a multitude of reasons.
We are likely to see foreign investors aggressively pursue downtown office towers that will inevitably come to market, make major investments in hotel or condominium projects, and provide construction financing for exciting new mixed-use deals. These groups want to park their cash in a safe place with a transparent rule of law, and Boston is on the short list.
Interest Rates: They are going up, plain and simple (unless something very bad happens and capital flows back into Treasury bonds, which creates some bigger problems for everyone). Is there an offset to this phenomenon? Lenders will get more aggressive on spreads, go higher on leverage, and provide more attractive differentiating features such as interest-only periods and earnout structures. And fundamentals – more rent growth, absorption, population growth, and lack of new supply (see “Development” above) – will keep the equity capital coming.
The world seems to be in a much better place than just a year ago, albeit imperfect and inefficient in many ways. We are still in the midst of a massive deleveraging effort, and many of the world’s economies are still in a fragile state. This will temper the pace of growth, which is just fine with me; a longer, slower cycle will be better for our market. But the silver lining is that the best companies are flush with cash, and capital spending has not begun in earnest. To maintain its competitive edge, Boston will need to be an attractive and affordable place to live and do business, and cultivate entrepreneurs. If we continue to innovate our approach to commerce and real estate, 2014 could be a banner year for our region.
Carlos Febres-Mazzei is a senior vice president for Debt & Equity Finance at CBRE. He is also an member of the advisory board for ULI Boston.
