Market forecast

Through the Looking Glass

The market outlook isn’t half bad.

As Americans struggle with the realities of a new normal — including slow economic growth, a $16 trillion debt load that has prompted new warnings by the major credit rating agencies, volatility throughout the world, and waning job growth — it is hard not to become discouraged about the state of the national economy and the outlook for all investments. The Federal Reserve has done nearly everything it can to spur growth, and Chairman Ben Bernanke has announced the Fed will buy $40 billion of mortgage-backed securities every month until the job market improves. But monetary policy alone cannot get the U.S. out of the hole it is in, and no matter how much we polish our looking glass, a new fiscal policy is unlikely to appear much different from what we have seen in the past.

Reflections on the Recent Past

Looking to the past gives us our best view of what to expect in the future. With respect to the national economy, Real Estate Research Corp. expects to see the sluggishness we have endured for the past several years to continue. Slow economic growth in the neighborhood of 2.0 percent, weak job growth, still-low interest rates, and volatility in the stock market are expected in 2013.

Despite lethargic employment growth, the low interest rates in this investment environment continue to favor safe investments, particularly commercial real estate. CCIM members who responded to RERC’s 3Q12 Investment Trends Quarterly survey gave commercial real estate their highest investment rating of 6.1 on a scale of 1 to 10, with 10 being high, followed by a rating of 5.4 for stocks, 4.5 for cash, and 4.3 for bonds.

Table 1 shows that year-to-date returns for the major stock market indices had increased significantly at the end of 3Q12. Although stock market returns continue to fluctuate, overall real estate returns have remained relatively stable. As determined by the National Council of Real Estate Investment Fiduciaries in the NCREIF Property Index, real estate returns will likely remain close to the averages shown.

As for the future, the relative safety of commercial real estate as an asset class is likely to continue to be critical for investors in the year ahead. Real estate is tangible and transparent, and it offers reasonable returns as an investment alternative, particularly in periods of volatility, which we expect as long as the challenges in the national economy continue. We are starting to see required pre-tax yield rates and going-in capitalization rates decline slightly for the office, industrial, and neighborhood/community institutional retail markets (see Table 2). However, compared to 10-year Treasuries (see Figures 1 and 2), commercial real estate returns should remain relatively stable.

Coming Clean in 2013

For the most part, commercial real estate has come clean: It has been re-priced appropriately and values are reasonable. Commercial property in the primary markets, particularly the coastal markets, is fully priced. In addition, lack of confidence and volatility in the stock markets, low bond yield rates, and low interest rates continue to favor the commercial real estate market as an investment alternative.

In addition, most cities and states have made the kinds of adjustments required to get their fiscal position in order during the past couple of years. Many regions and markets have successfully set priorities, made difficult but necessary decisions, and balanced their budgets. We saw increasing numbers of commercial property transactions in secondary and tertiary markets throughout 2012. This trend should continue due to the general improvement in regional economies, which has been boosted by local manufacturing, improving job growth, and stabilizing home prices. Further, commercial property re-pricing is taking place in these markets and distress continues to be resolved, which should continue as long as interest rates remain low.

CCIM members have also noted the strength in the regional economies compared to the national economy, and rated their regional economies accordingly in 3Q12. The East regional economy earned the top rating of 6.1 on a scale of 1 to 10, with 10 being high, followed by the West with a rating of 6.0. The South regional economy was rated at 5.6, and the Midwest at 5.3. In contrast, the national economy was rated at 4.9 during 3Q12.

Fundamentals Improve

Despite weak job growth, vacancy in the major commercial property sectors has continued to improve during the past year. In the national market, apartment sector vacancy has declined 100 basis points since 3Q11, compared to the retail sector where vacancy has declined only 20 basis points in the same period. Rental growth has been mostly flat throughout the year, except for the apartment sector, where apartment rent has increased so much that we are again seeing the cost benefits of buying a home versus renting. In addition, 3Q12 total sales volume of commercial property decreased year-over-year on a 12-month trailing basis, with less volume noted primarily in the office, retail, and hotel sectors.

Office. The office sector’s vacancy declined to 17.1 percent in 3Q12 from 17.4 percent a year earlier, according to Reis. Absorption was positive throughout the year, although asking and effective rents increased only slightly (approximately 35 cents to 50 cents per square foot on average). The total volume of office properties declined to $60.2 million on a 12-month trailing basis in 3Q12, which was lower than a year ago and compared to the previous quarter’s volume, according to RERC’s transaction analysis. The size-weighted average price dropped to $177 psf on a 12-month trailing basis.

Industrial. The industrial sector’s availability rate fell to 13.1 percent during 3Q12, which is the ninth consecutive quarter in which the industrial availability rate has declined, according to CBRE. Total sales volume of industrial properties increased slightly to more than $30.7 million in 3Q12, higher than a year ago and the previous quarter’s sales on a 12-month trailing basis, per RERC’s transaction analysis. In addition, the size-weighted average price of industrial space increased to $55 psf on a 12-month trailing basis.

Retail. The retail sector’s vacancy remained at 10.8 percent in 3Q12, down only 20 basis points from 3Q11. Asking and effective rents for neighborhood and community centers were flat, increasing an average of only 8 cents psf over the year, according to Reis. However, this is the first year since the recession began that absorption was positive during each quarter. RERC’s transaction analysis shows that 12-month trailing total retail sales volume decreased to $40.5 million in 3Q12, which was down from YOY volume and from prior-quarter volume. The size-weighted average price of retail space decreased to $136 psf in 3Q12.

Apartments. Although fundamentals continue to improve for the multifamily sector, volume and price declined in 3Q12. The vacancy rate for the apartment sector declined to 4.6 percent during 3Q12 compared to 5.6 percent a year ago, according to Reis. Net absorption began to slow, but asking and effective rents increased $35 to $40 per unit during the year. According to RERC’s transaction analysis, total transaction volume for the apartment sector decreased to nearly $56.8 million in 3Q12 on a 12-month trailing basis, which was higher than year-ago volume, but less than 2Q12 volume. The size-weighted average price per apartment unit increased to $90,848 on a 12-month trailing basis, which was higher than the year-ago average price but lower than the 2Q12 price.

Hotels. Third-quarter 2012 hotel sector occupancy rose to 64.2 percent, a 2.5-percent YOY increase, according to Smith Travel Research. The average daily rate was up 5.4 percent to $106.60, and revenue per available room increased 8.0 percent to $68.43. However, RERC’s transaction analysis indicates that total sales volume for the hotel sector declined to more than $12.3 million on a 12-month trailing basis in 3Q12, which was lower than both year-ago volume and prior-quarter volume. The price for hotel rooms also declined compared to both year-ago and previous-quarter pricing, with a size-weighted average price per unit of $89,832 on a 12-month trailing basis in 3Q12.

Secondary and Tertiary Markets: Better Times Ahead

With respect to commercial real estate returns in the secondary and tertiary markets, Charlotte, N.C., has seen total returns of 13.55 percent and income growth of 6.99 percent during the past year, according to RERC’s analysis. Apartment vacancy declined 180 basis points during the past year in Charlotte, with effective rental growth increasing approximately 3.5 percent, according to Reis. Industrial sector vacancy declined 30 basis points and saw 2.16 percent effective rental growth over the past year, while retail sector vacancy declined only slightly and effective rental growth increased 0.51 percent. In contrast, office sector vacancy increased slightly and rental growth was meager.

Cleveland is another market that is seeing a positive transformation, with total returns of 6.27 percent during the past year, primarily based on the improvement in capital returns from -8.24 percent during the past three years to only -1.9 percent in the past year. In addition, income growth has increased consistently during the past few years to 6.16 percent during the past year, according to RERC’s analysis. This market has also been led by meaningful vacancy declines and effective rental growth increases in the apartment and industrial sectors. Retail vacancy also improved, although effective rental growth remained flat, while office sector vacancy increased and rental growth was weak.

Despite a decline in total returns to 4.25 percent in 2012 from 6.72 percent in 2011, per RERC’s analysis, the income growth in Columbus, Ohio, rose to 9.45 percent this past year. Property performance generally followed that of the Cleveland market, but because of the change in income and a decline in office vacancy, this metro offers better investment opportunity.

Other metropolitan regions that are starting to pull out of the mire include Las Vegas, with a net change in income growth of 1,100 basis points, the largest growth of any of the top 48 metro regions. Even Detroit, which has been heavily undervalued in the past, has shown continually increasing income.

Among some of the safer markets, total returns increased 12.09 percent over the past year in Nashville, Tenn., with even the office sector showing improvement. Houston and Denver are showing solid income growth, and the office sector, which is the most underperforming sector, is seeing declining vacancy and increasing effective rental growth. In addition, Minneapolis appears to have good growth potential from a capital returns perspective.

An Improved View of Risk

As risk and uncertainty continue to dominate the investment environment, relatively safe and solid investments will continue to earn lower yield as noted by the nearly nonexistent returns for Treasuries or cash holdings. That is partly why commercial real estate, with its reasonable income returns and potential for growth, is attractive as a long-term investment.

Despite the relatively strong fundamentals and stability of this asset class, commercial real estate is not without risk, given its dependence on job growth and other economic factors. However, as illustrated in the fundamentals, total returns and income on this asset class are slowly improving, and more importantly, CCIM members expect this trend to continue. CCIM members gave commercial real estate an overall return versus risk rating of 5.5 on a scale of 1 to 10, with 10 being high, in 3Q12, as this asset class gained appeal (Table 3). When looking at the individual property sectors, the safest property types earned the highest return versus risk ratings, such as the apartment sector with a rating at 7.2. At 4.9, the office sector has the lowest return versus risk rating, indicating that there is slightly more risk involved with this sector.

As we have seen over the past few years, commercial real estate can be the refuge investors need as they peer into the looking glass, seeking relative safety and reasonable returns. However, for investors to make the best use of the real estate looking glass, close scrutiny of the facts and fundamentals, proper illumination of the investment environment overall, and an objective look at the reflection peering back are needed.

Kenneth P. Riggs Jr., CCIM, CRE, MAI, is chief real estate economist for CCIM Institute and chairman and president of Real Estate Research Corp. in Chicago. Contact him at riggs@rerc.com.

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