Small-Cap ‘Crosswinds’ Emerge

Demand for small-cap commercial real estate stayed in positive territory but continued to erode during the second quarter, reported Boxwood Means, Stamford, Conn.

“It’s too early to raise the warning flag, but the recent deceleration in aggregate small-cap net absorption is nonetheless concerning,” said Boxwood Means Principal Randy Fuchs.
He said “crosswinds” are emerging in the sub-50,000 square foot commercial real estate sector.

Generally, the report noted favorable small-cap space market and investment fundamentals progressed through second quarter. Yet the occupier demand trend may create headwinds for future growth,” Fuchs said, noting net occupancies across office, industrial and retail sectors declined more than 8 percent between the first and second quarters and a “sizable” 45.7 percent year-over-year.

Not only is the second quarter’s absorption increase the lowest seen in 24 quarters, the 37.4 million square feet of total occupancy gains for the first half of 2018 represents the weakest mid-year performance since 2011, when the commercial real estate market began expanding in earnest. Only the office sector witnessed increasing demand, jumping more than 72 percent to 6.0 million square feet, but that represented a “rebound” from an abnormally low first-quarter figure, Fuchs said.

Fuchs called low vacancy rates a double-edged sword. “Most analysts perceive low vacancies as a good thing, clearing the market of excess space while satisfying tenant demand,” he said. “And in this mature commercial real estate market, we should anticipate that very low vacancies invite new inventory that would temper scarcity and bring supply and demand fundamentals back into better balance. But when record low vacancy rates fail to engender an adequate supply of new construction projects, tenants seeking relocations or expansion space will likely be frustrated in that endeavor and also discouraged by soaring rents. This is a telltale sign that markets have fallen into disequilibrium.”

Meanwhile, a recent softening trend in small-balance lending originations cannot be ignored, Fuchs said. Total quarterly originations were the lowest in four years and declined quarter-over-quarter and year-over-year by 9.7 percent and 14.4 percent, respectively. “The slowdown in small-balance lending volume arises as a consequence of higher interest rates, a sizable contraction (25.6 percent) year-over-year in purchase loans and perhaps an associated tilt toward more cash deals,” he said.

The ongoing shift in small-balance lender composition continues, Fuchs said. Commercial banks still dominate the leader board, but their collective market share plunged to 18 percent from nearly 23 percent few years ago as competition from alternative and non-bank lenders progressed. “It comes as no surprise that a rising tide of alternative lenders have made their presence felt since overall small-balance lending competition naturally surges with a maturing commercial real estate and credit cycle–as last witnessed at the market’s 2007-2008 peak,” he said. “If the softening trend in small-balance lending originations persists, it’s likely that the staying power of some of these non-banks will be tested.”