Ten-X Commercial, the nation's leading online real estate transaction marketplace, released its latest Commercial Real Estate Volume & Pricing Trends report (formerly the Capital Trends report), which reveals that investment activity increased in Q3 2017 for the second consecutive quarter. Transaction volume rose 3.2 percent quarter over quarter, reaching $109.5 billion, according to Real Capital Analytics.

While investment activity remained above the $100-billion threshold, deal volume was far below its cyclical peak and 9.6 percent lower than a year ago. In the midst of continuing economic expansion, the moderation in commercial real estate capital markets is striking. Much of the sector is suffering from stagnation in both deal volume and pricing due to new supply dampening net operating income growth and a pricing expectations gap between buyers and sellers.

Continuing policy uncertainty is also weighing on capital markets, as tax reform proposals currently under development could potentially have serious repercussions for the housing market, corporate tax rates and pass-through income. While the Fed is likely to continue raising interest rates and reverse quantitative easing, credit spreads have thus far remained extremely narrow, while interest rates have been stable in the 2.0 percent range.

"Investors recognize the advanced age of this economic expansion and many are wondering when it may be coming to an end," said Ten-X Chief Economist Peter Muoio. "With sellers holding their ground, CRE pricing expectations are diverging, which led to a Q3 marked by tepid deal volume and pricing."

After dipping below $100 billion earlier this year, Q3's $109.6 billion in deal volume marked the second consecutive month in which activity exceeded the threshold. However the figure is well below the cyclical peak and down a whopping 9.6-percent year-over-year from Q3 2016, when commercial real estate proved resilient to Brexit volatility and U.S. presidential election uncertainty.

Of the five market sectors, only apartment and industrial showed improved deal volume from the previous quarter. Losses across the other three sectors curbed the gains, pulling overall investment activity to just a modest 3.2 percent increase from Q2.

The apartment and industrial sectors continued to account for an outsized share of total deal volume, reflecting their popularity among investors. The apartment sector alone comprised 36.4 percent of total deal volume. Office suffered the largest quarterly decline in deal share, shrinking nearly 420 bps to 26.2 percent. With retail's quarterly decline, the sector fell below its 10-year average to just 12.1 percent of overall deal volume. Hotel, which is suffering from widely divergent buyer-seller pricing expectations, also saw its portion of overall transaction volume decline modestly.

Property Pricing

Property valuations are now up 1.5 percent year-over-year as of November per the Ten-X All Property Nowcast, which gauges national pricing through a combination of proprietary and third-party data. With November's All-Property Nowcast edging down 0.1 percent from October's mark, pricing has now declined for seven consecutive months to reach the weakest annual growth on record — a stark reversal following 14 straight months of growth.

The Ten-X Industrial Nowcast fell 1.1 percent in November, the sixth decline in seven months, resulting in an annual pricing drop of 3.2 percent. Industrial's weak performance is particularly striking in light of the positive demand dynamics currently at play. Industrial vacancies continue to decline to lows not seen in decades while supply remains relatively modest. The pricing slowdown in this environment likely indicates that investors simply believe pricing has gotten ahead of fundamentals and are unwilling to overpay to acquire coveted industrial facilities. 

The apartment sector continued to weaken with the Ten-X Apartment Nowcast falling by 0.2 percent – its fifth straight monthly decline. Apartment pricing is now just 3.4 percent higher than a year ago – another new low for the current cycle. According to REIS, national apartment vacancies ticked up to a seasonally adjusted 4.5 percent, breaking out of the 4.1 percent to 4.4 percent range they have held over the last 18 quarters as absorption fell to a five-year low.

The hotel sector fell by 0.5 percent in November, the fifth decline in seven months, bringing annual pricing growth to a paltry 0.1 percent. U.S. hotel occupancies have made little headway over the last 12 quarters and the Nowcast corroborates ongoing weakness in this segment.

Despite retail's ongoing struggles, the sector climbed again in November, up 0.6 percent month-over-month, its sixth consecutive monthly gain. This brings the segment's annual pricing growth to 5.8 percent.The sector's headwinds, namely the growth of e-retail and ever-shrinking store footprint, make this result particularly surprising.

The Ten-X Office Nowcast edged 0.5 percent higher in November. However, year-over-year growth slowed to 0.9 percent, suggesting the sector may have reached a plateau as annual growth is now well off the double-digit pace that prevailed from mid-2015 to mid-2016.

Risk Premiums Show Little Movement

Risk premiums – cap rates less the risk-free treasury – remained largely unchanged in the third quarter, with four of the five sectors seeing movement of less than than 10 bps. Office and apartment risk premiums were flat quarter-over-quarter, while industrial edged up 10 bps and hotel ticked down 10 bps. The retail sector saw the only risk premium change of over 10 bps during the third quarter, down 30 bps from the second quarter to 370 bps. That figure is in line with the sector's 2016 fourth quarter level, but down 80 bps from a year ago.

While all five sectors are trending more than 100 bps below their cyclical highs, the hotel sector has seen premiums drift back up near its 10-year average. With slowing occupancy and room rate growth diminishing, investors' rate of return and cyclical tides shifting against the sector, investors are showing less confidence in returns on hotel properties.

The other component of cap rates, 10-year Treasury rates, also remained unchanged since Q2 at 2.2 percent. Though that mark places them 60 bps higher than a year ago, the Fed has signaled an intention to hike rates again in 2017.

Hotel Barely Beats 10-Year Average Cap Rates

With treasury yields unchanged, cap rates did not move more than 30 bps in any sector in the third quarter. Per Situs/RERC, office and apartment cap rates were flat at 5.8 percent and 5.0 percent, respectively. Retail declined 30 bps to 5.9 percent, a level that is within 10 bps of the sector's cycle low from year-end 2014. Hotel cap rates declined 10 bps and are now below their 10-year average by 50 bps. All other sectors are beating their long-run measurements by at least 70 bps.

"The third quarter of 2017 provided a mixed bag of results across commercial real estate, with a real estate cycle that is past its peak and CRE pricing that continues to tick downward," said Muoio. "Despite this, the low interest-rate environment has driven a respectable amount of investment activity and supported cap rates below their 10-year averages in all property segments.