Smaller Commercial Properties are on the Upswing

Big trophy properties in larger cities have certainly benefited from the recent strong real estate market, but bigger story recently has been about the recent resurgence of smaller …

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Big trophy properties in larger cities have certainly benefited from the recent strong real estate market, but bigger story recently has been about the recent resurgence of smaller commercial properties. 

Transactions involving assets priced under $5 million were at record levels during 2015, even as higher-priced locales like Manhattan and San Francisco became too pricey for many institutional investors.  Sales volumes of small-cap assets — which were up 14.4 percent through the first half of 2015, as compared to 2014 — are moving at the fastest clip since at least 2005.

The Small-Balance Difference

The small-balance commercial real estate market behaves a bit differently than that for larger Class A properties.  Global investors don’t seem to chase the small-balance market, for one thing.  Another differentiator is that the small-balance commercial market tends to move more in tandem with the residential housing space, which has also ticked up as of late.

The investor who buys a small-cap property is a different breed from the REITs and pension funds that have been buying up large assets in San Francisco and Manhattan, according to George Ratiu, a commercial analyst with the National Association of Realtors.  The investor in smaller assets often needs to take out commercial bank loans to purchase a restaurant, a strip mall or warehouse building. 

While individual properties can sometimes be riskier if they are based on only a few tenants, in other respects the small-balance market seems to exhibit some degree of stability.  “The prices in the small-cap CRE (commercial real estate) domain don’t have the same peaks and valleys as the large CRE market,” said Randy Fuchs, principal at Boxwood Means, a research group that surveys trends in smaller commercial properties.

Small is Beautiful?

Small-balance commercial real estate is also an increasingly fragmented market.  The top 15 small-balance lenders took over 20 percent of sub-$5 million originations during Q2 2015, for example, but those same banks seem to be shedding small-balance real estate loans.  “Despite their dominance in the small-balance commercial space, commercial banks face increasing competition for smaller loans, especially from the growing herd of alternative and non-bank lenders,” said Fuchs. “The trend of small business real estate loans within bank portfolios is declining — and seemingly irreversibly so.”

Record-low vacancies and recurring gains in leasing demand would seem to assure another solid year for the small-balance space, according to a recent Small Balance Advocate report.  Rents for small cap warehouse and flex buildings are doing particularly well, with office and retail rents also on the rise, albeit at a more modest pace.

Some of the market’s attractiveness can be ascribed to a continued relatively lack of new construction projects.  The pace of construction in Q2 2015 was at just 40 percent of the long-term quarterly average rate.  "It is a bit of a head-scratcher that developers of smaller buildings have not responded to the very tight vacancies that exist in the small-cap domain," Fuchs said

Enthusiasm for development by industry participants seems to be curbed by insufficient rents and the somewhat indeterminate course of the nation’s economic recovery. Rent growth is likely to persist as long as the demand-supply gap persists.

Lands of Opportunity

Certain areas in California are leading the comeback, while annual returns for selected Florida cities are among the best in the country, including Sarasota and Fort Lauderdale.  To some extent these latter regions are “playing from behind,” since they had precipitous losses during the recession. As a result, however, lenders and investors may still find attractively priced assets in some of these markets.

In general, large cap CRE price trends (seen, for example, from the Core Commercial (CC) component of Moody’s/RCA CPPI), suggest that some investors and lenders are pursuing higher-risk strategies in the high-end market.  Higher asset prices and associated lower returns are leading some to hope that more economic growth will prop up values.  Large-cap prices seem to have increased, too, in secondary and tertiary markets, even though property fundamentals in those non-major markets have not recovered nearly as much relative to major markets.

Small-cap CRE investors face similar opportunities and risks in local markets, but the lower prices at which many of these assets still trade may offset the risk of any overly ambitious capital growth expectations. 

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