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Good news, bad news in small-cap CRE market


Tenant demand in small-capitalization commercial real estate (CRE) assets remains sound, although one observer warns that there is concern for the future due to “cracks in the foundation.”

VacantCREThose cracks, according to Boxwood Means, come in the form of slowing growth in aggregate occupancy gains. The commercial-property analytics company's numbers say that fourth-quarter 2018 continued a run of 33 consecutive quarters of positive net absorption across the office, industrial and retail sectors. But the 26.1 million square feet of aggregate occupancy gains in the past fourth quarter marked a 40 percent year-over-year decline. That number represents the lowest fourth-quarter total since 2011.

Moreover, the net absorption of 103.2 million square feet for all of 2018 was more than 20 percent less than 2017’s total. It’s the lowest annual amount in six years — and that’s after a precipitous drop from 2016 to 2017.

Randy Fuchs, a Boxwood Means principal and co-founder, isn't about to yell "fire" in a theater just yet, especially given the rosy picture of overall commercial-market growth. But he concedes that “there is some slippage going on,” and as Boxwood’s fourth-quarter small-cap CRE report points out, that deceleration raises questions about future market expansion.

“It is tough to get underneath it, because on some level that, while we generally agree that the small-cap market is intact and fundamentally sound, at the same time, there are some signals coming out that the market is coming out with some changes on this,” Fuchs said.

“We find that, for example, that the tight labor markets, especially for small businesses, are creating problems. Now, obviously, small businesses are a major demand driver for small-cap commercial real estate. The news that is coming out on Main Street businesses indicate that there are some new challenges to sustain growth.”

Part of the labor-market challenges stem from the double-edged sword of the nation's low unemployment rate. Many small businesses are having difficulties finding new workers, which can alter their plans for expansion and needs for space. But other challenges — such as skyrocketing rents and a small number of vacancies for small-cap space — continue to endure and even swell. Combine that with moderate new-construction activity and you have a recipe for small-cap growth losing its tailwinds despite a strong run.

Slowing growth is consistent across property types. Industrial real estate net absorption was down 22.3 percent year over year in 2018. Retail properties saw a 17.7 percent absorption decline during the past year, while office properties saw an annual decrease of 4.1 percent. Examining fourth-quarter movements alone paints a starker picture: Industrial and retail absorption rates dropped by 52.9 percent and 46.1 percent, respectively, while office properties eked out a 1.4 percent gain.

Small-cap CRE sales are beginning to mirror the demand trend. Through October 2018, sales involving transactions of $5 million or less totaled $102.6 billion — a dollar volume that is 5 percent healthier than the record pace of 2017. But the flurry of sales in 2018 have carried on despite hurdles such as high prices, low capitalization rates and escalating debt costs, and those factors are starting to have an impact. Consider that, despite the bounce back this past October, year-over-year sales volume has a trend line that is sharply sloping downward.

Although Fuchs aims to shed light on the clues behind a potential decline, he also isn’t predicting doom and gloom. Rather, Boxwood Means is projecting plenty of opportunity in 2019, but is cautioning investors that increased risk management may be prudent.

“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," Fuchs said.


 

Questions? Contact at (425) 984-6019 or arniea@scotsmanguide.com.

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