In mid-February, Morgan Stanley analysts issued a prediction that the commercial real estate market in California and across the United States would post a growth rate of zero percent in 2016. The opinion was surprising because the firm previously forecast that prices would grow 5 percent this year, and the market has shown explosive growth in recent years, exceeding its pre-financial crisis highs.
Morgan Stanley analysts said that the reason behind their forecast shift is due to the dynamic between property values and lenders. Typically, commercial real estate investors are looking for a particular leveraged return profile when they make an asset class purchase. However, when property prices fall, it results in lower loan-to-value ratios. This drops leverage, which means investors need to make up the loss elsewhere. The analysts said they found that a 10 percent drop in the loan-to-value ratio needs an annual net operating income growth of 2.25 percent to offset the loss. In order to maintain their returns, CRE investors would have to see a rise in the income generated from properties. The analysts believe that is unlikely to happen due to a slowdown in corporate earnings, the threat of a recession and rising financing costs.
Other CRE experts believe that 2016 could see a divide between high- and low-quality commercial properties. There could also be a division based on funding sources.
The commercial real estate market is complex and ever changing. California investors may benefit by consulting with an attorney familiar with the market before entering into any agreements.
Source: Boomberg, "Morgan Stanley Says U.S. Commercial Real Estate Price Growth Will Be Flat," Tracy Alloway, Feb. 23, 2016