The 2015 outlook for commercial real estate and commercial mortgage-backed securities (CMBS) is positive but returns are expected to moderate. Growth will depend more on increases in net operating income rather than declining cap rates. Occupancy rates are projected to remain stable or improve across major property types except multifamily and lodging, which may have peaked. Construction pipelines are growing in some markets, which could impact vacancy levels. Demand trends vary across major and non-major markets. The industrial sector remains resilient due to e-commerce and manufacturing.

1. Written by Mark Heschmeyer (mheschmeyer@costar.com)
January 07, 2015
10 Takeaways from 2015 CMBS Outlook About Property
Fundamentals, Markets
News: National
Returns Expected to Moderate as Price Appreciation Switches from Cheap Deals to Solid NOI
Performance
The 2015 outlook for the commercial mortgage-backed securities (CMBS) market by various analysts is
painting another strong year for commercial real estate. Importantly though, the dynamics among various
markets and property types will shift driven by changes in job growth, shrinking tenant space needs, new
construction and falling cap rates.
"As the effects of the Great Recession fade and economic growth accelerates, the commercial real estate
market has found its sweet spot," report CMBS analysts Lea Overby and Steven Romasko at Nomura
Securities. "A growing economy has resulted in higher demand for space, and limited supply has enabled
property owners to push rents. These improvements, as well as further easing of credit conditions, will
likely further bolster the performance of commercial real estate and CMBS [in 2015]."
Also, investors are expected to have increased confidence that commercial real estate and CMBS
financing provide a relatively safe opportunity to pick up additional yield, given its strong performance
and an improving economic outlook, the analysts added.
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Historically, CMBS has tended to gain market share as a source of capital versus banks and insurance
companies late in the credit cycle, according to Chris van Heerden, head of CMBS Research at Wells Fargo
Securities. However, he is projecting continued strong capital flow into CRE.
While van Heerden does not expect market share to shift dramatically among lender types, at the same
time, the competition to meet growing loan demand from both increased investment activity and a loan
maturity pipeline should favor borrowers but increase the risk profile of lender portfolios.
Kroll Bond Rating Agency expects the economy to continue expanding and that CRE fundamentals will
remain stable across all of the property type segments, many of which will experience flat to modest
growth.
Based on the CMBS industry observations, here are 10 takeaways about the outlook for property market
and fundamentals.
1. Growth from NOI Replacing Tightening Cap Rates
Commercial real estate should directly benefit from continued acceleration in economic activity expected
in 2015. Nomura Securities expects occupancy rates to improve across all major property types, giving
owners more room to increase rents. Property prices are also expected to continue increasing, although at
a decelerating pace, with future price appreciation likely to rest on increases in net operating income
(NOI), rather than tightening cap rates. Should NOI growth continue, transaction volume will likely rise
along with property investors' confidence, resulting in additional equity flowing into the sector.
2. Trends in Occupancy
Through the first three quarters of 2014, occupancy levels for office, retail and lodging properties
continued to increase, while the multifamily sector appears to have peaked. The two largest sectors in
CMBS, office and retail, were slow to recover after the crisis due to longer lease terms and shifts in
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2. CONTINUED: 10 Takeaways from 2015 CMBS Outlook About Property Fundamentals, Markets
tenants' space needs, according to Nomura Securities. While these sectors have not yet fully recovered,
occupancy rates are now at post-crisis highs, and growth is expected to continue for the next few years.
The two smaller CMBS sectors, multifamily and lodging, have both shown strong growth following the
crisis, with occupancy levels now exceeding pre-crisis peaks. However, both have little room for
improvement may have reached a peak as new construction limits additional increases.
3. Retail Should Stabilize
The retail sector continues to suffer from shifting consumer behavior and an increase in online retailing,
Nomura's securities analysts said. However, with very little new retail construction since the crisis, the
sector is making a slow but steady comeback, with occupancies expected to stabilize. Further, the market
has bifurcated into well-occupied, stabilized properties and those that are unlikely to survive.
There is continued divergence in performance between dominant class-A malls and inferior malls, Fitch
Ratings agreed, and warned that second- and third-tier malls can be subject to relatively rapid and
substantial performance declines leading to outsize CMBS losses.
Meanwhile, a variety of challenges are expected to continue to constrain the performance of many
retailers in 2015, according to Fitch Ratings. Persistent pressure on low income consumers shows no sign
of abating. Longer-term trends of growing online competition and declining store traffic are not expected
to reverse in the near term.
In 2015, Sears and JC Penney top the list of retailers of primary concern. Both struggled in 2014,
although JC Penney is starting to show some positive traction and has improved its liquidity profile over
the past few months. However, Sears was further downgraded to ‘CC’ in September 2014 due to serious
liquidity concerns by ratings agencies.
4. Trends in Asking Rents and NOIs
The recent improvements in occupancy rates in the office, retail and lodging sectors have allowed
landlords to push rents, while multifamily owners have been able to maintain rental growth even as
occupancy has started to slip. Across the four major property types, multifamily and lodging properties
now report asking rents exceeding their pre-crisis highs.
Citing CoStar Group data, Nomura analysts projected that rents will continue to rise at a steady pace over
the next few years as construction remains muted. Office properties are likely to fully recover by mid-
2015, while retail properties to continue to lag, with full recovery not expected until 2017.
With occupancy rates likely to increase or remain flat and rents likely to rise, NOI should continue to
expand across all four major property types for the next few years. Through the third quarter of 2014,
NOI exceeded pre-crisis levels for the multifamily sector by 8%, while the lodging sector reported an 11%
increase. In contrast, the office and retail sectors have not yet fully recovered and are now 8% and 11%
below their pre-crisis peaks, respectively.
5. Construction Pipeline Is Growing
Wells Fargo Securities highlighted the top 10 markets by property type expected to see the largest
amount of new supply through 2016 measured as a percentage of current inventory levels and based on
current supply pipeline data. Markets such as Charlotte, Denver, Raleigh-Durham, Suburban Virginia, San
Jose, Oakland, Las Vegas, Miami, San Francisco, Houston, Dallas and Orlando appear in the top 10 in at
least two property types, while Austin, Charlotte, and San Jose make the top 10 in at least three property
types.
Fitch Ratings is also monitoring construction activity in certain markets for potential overbuilding. Markets
such as Charleston, SC, Austin, TX and Charlotte, NC are expected to have continued supply growth that
will impact vacancy levels in these markets; these levels are already slightly higher than the national
average.
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3. CONTINUED: 10 Takeaways from 2015 CMBS Outlook About Property Fundamentals, Markets
6. Investors Pricing in Cap Rate Risks
While property investors may initially wince at cap rates reverting to 2007 levels, the spread between the
10-year Treasury and the average cap rate suggests that investors are still being compensated for
investment risk, according to Wells Fargo Securities.
Risk premiums across major commercial property types are well above the market peak in 2007 with
office, retail and industrial properties above the all-property average. Based on the data, Wells Fargo
analysts believe investors appear to be pricing in risk. They also believe a moderate rise in interest rates
against a backdrop of positive property revenue growth is unlikely to derail investor interest in CRE
property.
7. CRE Demand Nuanced Across Markets
Major markets have recovered 133% of their peak-to-trough losses, while non-major markets have
recovered only 75.7% of theirs, according to Morgan Stanley Research.
Morgan Stanley expects demand for major market properties will continue over the next year, driven
primarily by foreign investment, where cross-border investment in U.S. CRE properties is $37.8 billion and
for core properties is a 12% market share.
In non-major markets, returns will drive improvement. As property prices in major markets approach
peak levels, U.S. investors (and REITs specifically) are migrating to secondary and tertiary markets that
offer meaningfully higher cap rates. The levered internal rate of return (IRR) over a 10-year holding
period may be greater than 10% (assuming stable NOI, 70% LTV, and a 4.50% coupon). In Morgan
Stanley’s view, this creates a compelling levered yield profile with upside potential for the borrower, and
is a primary driver of demand for property types such as Class B and C retail properties.
8. Multifamily “Golden Age” Drives Issuance
With the home ownership rate having fallen to 64.2%, the lowest level since early 1995, Morgan Stanley
said it believes that government-sponsored enterprise (GSE) lending will accelerate in 2015 to meet
demand for rental properties. Freddie Mac for its part said it expects to issue $25 billion in multifamily
securities in 2015 across 17 to 20 deals. It will also be introducing a few new types of collateral to its
securitizations, including 10-year floaters and small balance loans.
9. With Office, CBD Is Still the Place To Be
The office sector is continuing to recover with the anticipation of a more broad-based improvement in
office-using employment across metropolitan office markets and secondary and suburban markets,
according to Fitch Ratings.
Those CBDs with large concentrations in the technology and oil and gas industries continue to outperform
in terms of average asking rents and occupancy. In addition to Houston, this group includes Seattle,
Silicon Valley, San Francisco, Boston and Austin. Rent increases in these cities are increasing demand in
collar markets and some select suburban markets. Cities with more diversified economies are also
benefiting as the overall economic recovery expands.
Overall, office supply remains mostly muted. However, select markets are experiencing significant office
development, with the largest including roughly 9.7 million square feet in Houston, 7.9 million square feet
in New York, 6.6 million square feet in Silicon Valley, 5.6 million square feet in Dallas and 4 million square
feet in Austin.
Cities such as Detroit, Baltimore, Orlando and Phoenix, which suffered severe economic losses during the
recession, continue to experience higher vacancies than the industry average. Nonetheless, these markets
are also improving and experienced an increase in asking rents between 0.5% and 1.9% from prior-year
periods.
In general, leasing activity outside noncore markets is requiring higher concessions and tenant
improvements, while owners in the best markets are gaining leverage in lease negotiations. As expected,
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4. CONTINUED: 10 Takeaways from 2015 CMBS Outlook About Property Fundamentals, Markets
weaker markets will continue to compete on price in attracting tenants, and may see increasing interest
from large users who are unable to find expansive available space in core markets, according to Fitch
Ratings' analysis.
10. Industrial: Ongoing Resiliency
Kroll Bond Rating Agency noted that the ongoing evolution of e-commerce and resurgence in domestic
manufacturing has infused resiliency into the industrial sector, which contributed to approximately a 100
bps drop in vacancy rates from a year ago. Citing CoStar Group data, Kroll reported vacancy rates for the
sector in Q3 2014 are around 7.0%, a 300 bps decline from the cyclical high of 10.3% in 2010.
In third quarter 2014, the industry had approximately 120 million square feet of space under
construction. Larger distribution markets with close proximity to ports continue to see the strongest
demand, according to CoStar Group data. Chicago, Dallas/Fort Worth, Inland Empire, and Philadelphia
accounted for one-third of the sector’s total absorption. The continued strength of the domestic economy
is expected to drive demand for space and result in increased rental rates.
Copyright (c) 2015 CoStar Realty Information, Inc. All rights reserved.