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Capitalization
rates are compressing and buyers outnumber sellers by a good margin,
making this one of the most disjointed markets for Twin Cities commercial
real estate investors in quite some time.
For one, private and institutional investors seem to have reversed
competitive positions, with the private buyers making a majority of the
transactions over the first half of the year.
Access
to low interest rate debt is helping fuel a surge in investment interest
by private investors, many of whom are structuring highly-leveraged
transactions to purchase properties. All told, private investors may have
held a 70-30 edge over institutions in terms of the number of transactions
completed over the first half of the year. That is a near total reverse of
what the situation was like in recent years, when institutional
investors’ cheaper cost of capital gave them an edge in the market.
Much
of the activity by private investors involves 1031 exchange transactions
in which investors defer capital gains taxes by exchanging one property
for another of similar or greater value. Now that the federal government
has taken some of the sting out of capital gains taxes by lowering the tax
rate to 15% from 20%, this type of investment strategy may be losing some
of its popularity. Investors may be more willing to take the immediate tax
hit at the lower rate on an investment property sale. However, the
recapture tax rate remains at 25%. The recapture tax is imposed by the IRS
on the seller of a building for deductions taken for depreciation during
the time the investor owned the property. It remains to be seen what
effect the new tax law will actually have on the commercial property
markets.
Buyers
and sellers are still seeking more common ground upon which to negotiate.
As strong as investor interest is for many types of commercial properties,
transaction levels remain relatively low. Even though income levels from
properties have declined as vacancies have increased and rents decreased
in many commercial property types, pricing has remained relatively firm,
thanks to the record low interest rates.
Property
owners have taken advantage of the low interest rates to refinance their
debt at lower levels and bolster their ability to ride out the current
downturn in commercial real estate markets. Buyers have lowered their
expected returns on investment in an effort to break the logjam, as
indicated by their increasing willingness to accept lower capitalization
rates in some property sectors.
Despite the slippage in market fundamentals, especially for office,
industrial and multifamily properties, the attraction of commercial real
estate as a desirable asset class for investors has not diminished. That
doesn’t mean that disparities don’t exist – the polarization between
what investors are willing to pay for higher quality, well-leased
properties and those with higher vacancies and other challenges has grown
ever sharper.
Investor interest is most intensely concentrated in retail and multifamily
properties. Quality grocery-anchored neighborhood and community shopping
centers are at the absolute bull’s eye of what many investors want, and
that situation is likely to become even more pronounced given the recent
changes in the Twin Cities grocery industry. Roundy’s Inc., the
Wisconsin-based grocer that purchased 30 Twin Cities Rainbow Foods stores
from Fleming Companies in June, is seen by many as bringing a new level of
competition to the marketplace that will revitalize many of the existing
Rainbow-anchored shopping centers.
Smaller, unanchored neighborhood shopping centers are also drawing
investor interest, especially from 1031 exchange buyers.
Demand for multifamily apartment properties among renters has cooled
somewhat over the past six months as vacancy increased to a metrowide
average of 6.7%. Still, the Twin Cities remains one of the most desirable
markets for multifamily investors. The metro area’s low unemployment
rate – at 4.3% well below the national average – along with continued
projected population growth, a diversified economic base and a constrained
market for new development give investors reason to look favorably on the
region.
Single-tenant buildings are a big demand item, especially for small to
medium sized companies. Demand for bulk warehouse properties is brisk, but
weaker for other types of industrial buildings.
THE OUTLOOK
Investment activity will likely increase over the second half,
especially as investors seek to fill out their asset allocations in real
estate for the year. Longer term, the health of the investment market
depends on a more robust recovery in the economy accompanied by
significant growth in hiring. Interest rates will likely remain relatively
flat for the coming six months, meaning that real estate investment
returns should continue to outshine returns on bonds.
Twin
Cities commercial real estate remains underpriced, compared to what’s
taking place in many other major metropolitan areas of the country. For
example, The Wall Street Journal reports that the average price for
office buildings in Central Business Districts nationwide soared 43% in
2002. Will more of that demand, coming primarily from institutional
investors including foreign investment sources, find its way to the Twin
Cities in the future? Stay tuned to see if this trend plays out in the
Twin Cities, as it has in other metropolitan areas.
Locally,
office pricing has been relatively flat – and major transactions have
been few. That may change if owners of some of the more stabilized office
properties in the Minneapolis and St. Paul CBDs, as well as in the
suburban submarkets, are put on the market in the next year. To date, few
of these types of properties have changed ownership hands in the Twin
Cities over the past couple of years.
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Insights on the capital markets were provided by NorthMarq Capital, one of
America's foremost real estate investment banking firms. The firm offers
its clients the ideal combination of a strong national company capable of
attracting a wide range of capital sources and an organization
strategically positioned to provide vital firsthand knowledge of local
markets. NorthMarq Capital is privately held by the Pohlad family of
Minneapolis.
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