U.S. property markets are increasingly signaling that they have peaked. But is this really the end of the cycle?

That’s what investors and real estate professionals want to know. As discussed in our recent 2016 Capital Flows Year-End Review and 2017+ Outlook Report, U.S. property markets seemed to be exhibiting tell-tale signs typically associated with the end of market cycles: record asset pricing, falling returns, flat capitalization rates, fewer leasing and sales transactions, and investors chasing yields into new markets and riskier assets. But those indications have only intensified since we issued the report.

Does this mean we’re near the end of the long (if moderate) property cycle that began in 2010? Or are markets just taking a bit of a breather before surging on to new peaks — “the pause that refreshes” to borrow a phrase from Coca-Cola*?

One reason economists hesitate to call turning points is that markets and economies are dynamic systems that evolve and pivot; even seemingly decisive turns can reverse course quickly. For example, property returns fell steadily from mid-2011 through late 2012, before stabilizing in 2013 and recovering in 2014 into 2015 — so we can only truly call the inflection with hindsight. That said, the mounting evidence certainly seems to point to the fact that the best years of this cycle are indeed behind us.

To be sure, both the U.S. economy and property fundamentals remain strong, and I do not anticipate a material near-term deterioration in either. 2017 looks to be yet another year of only moderate GDP growth, though job growth, retail spending and other important real estate drivers remain robust. Moreover, property occupancies and rents are still generally rising, though leasing seems to be moderating in many markets.

But the gains are slowing, particularly in capital markets.

We’re Way into Record Pricing Again

Perhaps the key marker for real estate markets is asset prices, which have experienced tremendous gains in this cycle, particularly in the major markets. According to the composite Moody’s/RCA Commercial Property Price Index (CPPI) for all markets, prices are now about 23% above their prior peak. But there is a significant spread between the top six markets and all others. The index for the major markets shows prices now 37% above their prior peak, compared to 9% above in the secondary markets.

These record prices are all the more remarkable because the run-up in values in the last cycle, which peaked in early 2008, were deemed by many analysts to be excessive. And yet here we are in the next cycle, comfortably above those previously lofty levels.

Sources: Real Capital Analytics and Colliers International. 

“Major markets” include Boston, Chicago, Los Angeles, San Francisco, New York and Washington, D.C. indexed where January 2001 = 100.

It is too soon to know if the current values will prove to be sustainable and provide the foundation for even higher prices. What we do know is that price gains have moderated considerably recently as cap rates generally stabilized and even started rising in early 2016 — a clear sign of market peaks.

Further, the moderating cap rates have been bringing down returns for property investors. As measured by the NCREIF Property Index (NPI) prepared by the National Council of Real Estate Investment Fiduciaries, returns have now fallen for eight consecutive quarters. And with the end of cap rate compression, appreciation returns account for most of the decline while income returns have remained steadier. Such patterns often — but not always — presage market peaks and economic recessions.

In Search of Yield in Less Expensive Markets

Though no recession seems to be in the offing, the record pricing and falling returns are inducing predictable responses from investors. Among other trends, investors are being more selective, increasingly resisting the premium asset prices as they chase yield by buying into less expensive markets.

Investors are shifting more capital out of central business districts (CBDs) and into more suburban submarkets, and from the major money centers to secondary markets. For example, CBDs accounted for 49% of all office transactions by dollar volume as recently as 2014; this share has fallen steadily to just 42% in Q1 2017. Similarly, the share of investment dollars going into the 10 largest U.S. markets peaked at 45% in 2012 and then fell steadily to 42% in 2016 before plunging to just 36% in the most recent quarter. This behavior, too, typifies end-of-cycle investment trends.

One positive trend to report is the relative discipline of investors in this cycle. Whereas investors poured capital into real estate as prices soared to new records in the last cycle, investors now are being more cautious. Accordingly, transaction volumes have fallen year-over-year in four of the past quarters as pricing has peaked. This restraint is all the more remarkable given the vast stockpiles of “dry powder” available to investors for new acquisitions.

Still, demand for product remains intense, particularly among foreign buyers less motivated by near-term returns. Nonetheless, many analysts concur that markets are looking a bit frothy — discouraging many buyers from investing, especially in the top markets. Together with the more moderate levels of construction volumes — in sharp contrast to the last cycle — these trends portend that the next downturn, whenever it occurs, will be much more moderate.

The End to Good Times … or a Pause?

Again, the strength in the underlying economy and key demand drivers suggest that the day of reckoning in property markets is not at hand. Furthermore, other, more transitory, factors likely contributed to the recent slowdown in real estate capital markets — most importantly, uncertainty about federal policy direction leading up to the election and then specific developments such as the rise in interest rates immediately following the election.

But the weight of the indicators nonetheless point to an end to the property cycle, or at least a serious pause. Indeed, RCA is reporting that preliminary estimates for April indicate another “high double-digit percentage decrease in deal volume versus a year ago” and generally flat prices. And similar trends are also playing out in the major markets of Europe (though not generally in Asia).

So, what to expect? We anticipate a further exodus of investment dollars from the top markets into secondary metros, and from CBDs into the suburbs. Also, while transaction volumes overall remain robust, we should not expect a return to prior peaks. Finally, with cap rates stabilizing in the major investment markets, value gains will likely moderate, limiting appreciation returns even as property fundamentals and income returns remain historically strong.

* Those looking for irony may note that Coca-Cola introduced its long-time slogan, “The Pause That Refreshes,” in 1929 — just in time for the Great Depression, one of the longest and deepest in our nation’s history. Not so refreshing after all.