The small commercial real estate market, or small-cap assets, has experienced steady growth since the post-recession recovery period started. Last year, asset sales and prices of smaller commercial properties hit new records, and fundamentals are strong across the office, industrial, retail and multifamily sectors.
Boxwood Means, an asset-valuation company, tracks the market for properties valued at $5 million or less, and typically tracks assets of less than 50,000 square feet. Boxwood Means principal and co-founder Randy Fuchs discussed small-cap trends with Scotsman Guide.
What is unique about the small-cap space that you track?
We have been in the business for 15 years now, and our research has shown that while the small-cap market tends to track generally with the large-cap or institutional marketplace in terms of sales and prices, and space-market conditions, there are some prominent differences. The small-cap market has a unique relationship with the residential housing market in that small-cap commercial prices tend to track the single-family residential prices more closely than they track the general commercial real estate institutional prices.
How is the market doing?
We are transitioning from a robust, national market expansion to a late-stage tapering of market growth and opportunity. The Q4 (fourth quarter) 2018 data showed that demand for space continued to be positive for the 33rd consecutive quarter across the office, retail and industrial sectors. Underlying that is the news that in the aggregate, across those property types, Q4 occupancy gains declined 40 percent year over year, and was the lowest [absorption] sum for that period since the second year of the recovery in 2011. So, there is some slippage that is going on, a deceleration in growth.
Why has there been a slowing in the demand for space?
It is tough to get underneath it. While we generally agree that the small-cap market is intact and fundamentally sound, at the same time, there are some signals that the market is changing. The tight labor markets, especially for small businesses, are creating problems. Small businesses are simply not able to find workers, and that trend [has been] slowing small-business growth for the last two years.
That shows up a little bit when we look at the total number of direct leases that have been signed over time using raw data from CoStar. There was a 21 percent reduction in the number of office, retail and industrial lease contracts signed in 2018 versus the prior year, and it is suggestive of a waning appetite for new facilities among small businesses.
Another factor is low vacancies. There is a severe imbalance in the small-cap market between demand and supply, and that is another factor challenging expansion-minded small businesses. That is, small-cap demand has been decelerating simply because of supply scarcity. Tenants that are expansion-minded are increasingly unable to find space.
What is the outlook for sales?
Through October of last year, we already crested $100 billion in property sales, so that was comfortably ahead of the record 2017 year-total pace of $120 billion. Even though 2018’s sales will probably be a new record, the trend in terms of the year-over-year changes in velocity of total volume is slowing. One of the drivers of property sales has really been the strong amount of debt capital that is being made available by so many different types of players in the small-balance space. So, you have marketplace lenders, specialty-finance lenders, debt funds. You have a broad range of players who are in this space providing debt capital, which has continued to fuel the market.
What is the biggest threat to the market?
There hasn’t been irrational exuberance that was present during the downfall of the last cycle. New construction has been moderate. Underwriting standards for banks have been fairly conservative. Given the lack of exuberance in terms of crazy, loose underwriting standards or hypersupply, it is more likely to be a soft landing than a crash that we saw last time, assuming no major economic disruption that causes a hard stop.
Generally, my position on that is no different than anybody else in expecting a continued slow deceleration in the market’s expansion, a tapering in growth and opportunity, but no big surprises and no big calamities.
