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Appreciation Shifts from Cap Rate Compression to Real Growth

Transaction Pricing an Early Indicator of Appraisal Pricing
June 17, 2013
CoStar's Property and Portfolio Research (PPR) division is forecasting that the wave of cap rate compression that has in some cases accounted for an astronomical 90% of the gain in core real estate value since the last recession is likely to slow; after all, trees do not grow to the sky.

Specifically, PPR's analysis of the top 54 U.S. markets finds that cap rates should remain within 20 basis points of today’s average through 2017, which will reduce the rate of real estate price growth relative to the recent past.


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Supporting the view that appreciation will slow, Exhibit 1 shows that transaction pricing gains, as reported by the NCREIF Transaction-Based Index (NTBI), were nearly 2% below growth reported by the NCREIF appraisal-based index (NPI).

This is significant because transaction pricing tends to be an early indicator of appraisal pricing, and the last time transaction-pricing growth fell below appraisal trends was at the start of the recent recession, in the second half of 2007.

Despite the expectations of slowing value growth through 2017, it is entirely possible that the market will continue to show some near-term cap rate compression due to the focus of capital on real estate.

After all, the equity REIT market experienced over a 40-basis-point decline in the dividend yield in the first four months of 2013; NCREIF transaction cap rates are 80 basis points higher on average than in the previous peak; and cap rate spreads to alternative investments remain wide.

Despite this potential trend, the source of real estate value growth is likely to shift in time from cap rate compression to rent, occupancy, and NOI growth. So, which markets are likely to outperform going forward?

The data in Exhibit 2, which shows the 10 markets with the greatest forecasted value increases across the four property types, suggests a few key trends.

1. As a late recovery play, the office sector offers double-digit capital value gains in eight out of the top 10 metros, suggesting that now is the time to overweight this sector.

2. Apartment opportunities are limited, as this sector is facing supply risks that will limit rent growth. However, Chicago and the East Bay are likely to be top performers within the sector.

3. Warehouse is also expected to do well, especially in San Jose and Portland, which are both benefiting from growth in technology employment.

4. Retail is likely to underperform, with none of the major markets achieving over a 10% cumulative capital value increase through 2017.

5. The Western markets, from San Jose north to Seattle, dominate the list of areas likely to outperform for most real estate property sectors, with housing-bust markets of Phoenix, Chicago, Miami, and Orange County also doing well, plus Austin.

In conclusion, our suggestions to investors are to lower value growth expectations compared to the recent past and focus on improving market and building fundamentals to achieve targeted returns.

Walter Page is Director of U.S. Research, Office for CoStar Group.






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