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Demand for small-cap properties weakens

A severe shortage of smaller commercial buildings continues to drive up rents and occupancy levels to record levels, even as businesses are now absorbing less space, despite a booming economy, according to Boxwood Means.

Overall, the small-cap market’s outlook remains strong. Small-cap commercial origination volume and sales involving properties valued under $5 million remained robust at the mid-year point, according to Boxwood Means. A significant drop in demand for space across all major asset types poses a risk to core fundamentals in the small-cap market, however.

smallcomNet absorption of space in smaller buildings stood at 20.4 million square feet in the third quarter. The third quarter saw net positive absorption for the 32nd consecutive quarter, but the rate of absorption has been slowing. The aggregate demand for buildings under 50,000 square feet has fallen for seven out of eight quarters. 

Boxwood Means analysts said the issue is tight inventory conditions rather than a faltering economy.   

“It could be a new normal — for now — represented by severely declining net absorption across office, industrial and retail sectors, even though Main Street businesses are reportedly very healthy and optimistic,” Boxwood Means principal Randy Fuchs told Scotsman Guide News.

“So, increasingly it appears that many small businesses and tenants have simply peeled back some of the facility expansion needs in the wake of fewer leasing opportunities and crushing rents. And, importantly, this pivot is not because they have turned cautious about the U.S. economy's outlook or their own,” he added.  

Fuchs said this severe supply/demand imbalance is proven by record occupancy levels and eye-popping rental growth. The national vacancy rate for small properties stood at a historic low of 4.3 percent, and vacancies for industrial, office and retail were each at least 1.5 percentage points or more lower than their previous record lows.

The construction pipeline hasn’t kept up. In 2017, new space delivered totaled 100 million square feet. Although this was the highest in eight years, it was “feeble compared with historic norms,” Fuchs said.

“Under these conditions, small-balance lenders, brokers and investors may find additional opportunities by working on creative facility solutions for expansion-minded small tenants and businesses, such as building acquisitions, conversions, or co-development with a sponsor,” Fuchs said. He noted that could be challenging, however.  

“These solutions won't be an easy layup since small-cap CRE [commercial real estate] assets in many markets are now trading at a premium in a still hot investment market,” he said. 

Origination volume involving assets valued under $5 million remained robust. The mid-year 2018 total was $107.6 billion, down by 11.3 percent from the same six-month period in 2017, but on target to exceed $200 billion for the sixth consecutive year. This was primarily driven by refinancing, which accounted for 62 percent of the volume.

Sales transaction volume through July totaled $69.7 billion, up 2.6 percent compared to the same period in 2017. Boxwood Means’ index charting prices in 125 markets reached a new peak this past July, up 6.2 percent year over year.


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