Shelter From the Storm
Commercial real estate offers investors refuge.
Editor's note: You can view the tables in the e-book version of this article.
Now that we are several
years past the credit crisis of 2008, the world is still in turmoil. The
European debt crisis and unrest in the Middle East — these global circumstances
set the tenor for U.S. economic concerns. Gross domestic product grew 2.0 percent
in 3Q11, but the federal debt grew to $15 trillion in 4Q11. Unemployment
remains at 9.0 percent, home prices are still declining, and although the
nation has dealt with many of its financial issues, the political climate is
the worst we have seen in recent history as attested by Standard & Poor’s downgrading of U.S. credit
businesses and consumers lack confidence, market volatility has increased, and
investors are tentative. It seems the only certainty is that uncertainty will
prevail throughout 2012, at least until the fall elections. The year 2012 will
serve as a foundation for new business growth, more deals, and getting our
ducks in a row for what is to come. Then we can finally turn the page to 2013, when
for commercial real estate to come clean.
Ballast in the Storm
Although the uncertainty
is dragging on, investors can take heart in the fact that commercial real
estate has been able to more than hold its own in this environment.
Commercial real estate has
held varying degrees of value throughout history, but compared to the banking
industry and other investment alternatives, it has always been tangible, mostly
transparent, and has served as a secure investment to which we have retreated
when times were tough. Given the uncertainty we are experiencing, this security
is a very appealing place to be — an investment foundation that is relatively
stable fits our needs quite well and, from an investment perspective, will
continue to for the next decade. Commercial real estate is able to deliver what
cannot be delivered by the alternatives.
As shown in Table 1, the
returns for commercial real estate for private institutional equity investors
are up strongly and exceed all other investments on a year-to-date basis
through 3Q11, according to the National Council for Real Estate Investment
Fiduciaries Index. Public equity investors are down on a YTD basis following a
strong bull run in the prior two years, according to the National Association
of Real Estate Investment Trusts Index. In addition, much of the loss we are
seeing in the NAREIT Index is due to the inherent volatility in the stock
market. In fact, as of 3Q11, institutional real estate investors are still
seeing a YTD annual rate of return of 10.97 percent according to the NCREIF
Index, despite the increasing risk. Most investors consider these returns quite
good on a relative or risk-adjusted basis.
Investors are fed up with
the volatile stock market, which can fluctuate 3.0 percent or more a day based
on news from overseas. Further, according to some estimates, 80 percent of
daily trading volume comes from high-frequency traders that are careless about
the fundamental value of the companies they are trading. Much of 2012 will be
spent cleaning up the volatility created by traders versus investors. The bond
market is a risky bet too, with interest rates at historical lows. As rates
rise — and they will one day — values will go down accordingly. The year 2012
will be a pivotal time for the financial markets, as investors separate the
wheat from the chaff.
As for commercial real
estate returns, we are already seeing moves toward stabilization among the core
property types, according to Real Estate Research Corp.’s institutional investment
survey respondents. As shown in Table 2, RERC’s required pre-tax yield rates and required
going-in and terminal capitalization rates increased or decreased only
slightly, if at all, for the office, industrial, retail, and apartment sectors.
In contrast, required returns for the hotel sector decreased somewhat
significantly from the previous quarter.
It does not take much
brain power to connect the dots when commercial real estate is providing
extremely attractive risk-adjusted returns versus Treasuries (Table 3). Analyses
required pre-tax yield rate (discount rate) and cap rates demonstrate returns
with spreads of 600 basis points and 450 basis points respectively, which are
above the long-term averages. Although Treasuries are at all-time lows, these
low rates are anticipated to continue for the next several years.
U.S. commercial real
estate continues to provide the ballast needed in this global financial storm
that remains fraught with moral hazard, lacks honesty and transparency, and has
turned the world on its head. It will take several years to deal with many of
these systemic issues in a world that operates between greed and fear, but if
commercial real estate does not come clean by 2013, it will be a lost relic of
the Great Recession.
Fundamentals Hold Their
Commercial real estate’s saving grace is that it
was not significantly overbuilt nor did it have a huge construction pipeline
when the recession began. As a result, property fundamentals continue to
improve, despite sluggish and downright dismal employment growth. The
interaction between demand and supply for commercial properties has translated
into stabilizing fundamentals relative to the dislocation felt throughout most
industries. Commercial space absorption is now positive, and new construction
remained at record lows in 2011. As a result, vacancy rates and rents posted
slow but steady improvements. This is what needs to continue for property
prices to inch up.
Office vacancy declined to
17.4 percent in 3Q11, while asking and effective rents increased 0.4 percent
and 0.6 percent respectively, according to Reis. RERC’s transaction analysis
indicated that total volume increased 20.0 percent, as the size-weighted
average price per square foot increased approximately 5.0 percent.
The availability rate for
industrial properties declined to 13.0 percent in 3Q11, according to Grubb
& Ellis, as new supply and rents increased slightly. Industrial property
volume increased about 10.0 percent on a 12-month trailing basis, but the
overall size-weighted average price per square foot declined slightly,
according to RERC’s
Despite a weak economy and
slow consumer spending, the retail sector vacancy rate remained at 11.0 percent
during 3Q11, according to Reis. However, net absorption remained negative, and
rents remained flat. Transaction volume increased nearly 10.0 percent on a
12-month trailing basis, and the size-weighted average price psf of retail
property space increased slightly, according to RERC’s analysis.
With a vacancy rate of
only 5.6 percent during 3Q11, according to Reis, increasing rents, and positive
net absorption, it is easy to see that the multifamily sector poses minimal
risk nationally, regionally, and in most metro areas. Apartment sector volume
increased 15.0 percent on a 12-month trailing basis, although the size-weighted
average price per unit declined slightly, according to RERC.
Hotel occupancy rose to
62.8 percent in 3Q11, according to Smith Travel Research. The average daily
rate and revenue per available room also increased. RERC’s transaction analysis
showed that total volume for the hotel sector rose 10.0 percent, but the
overall size-weighted average price per unit decreased about 5.0 percent.
All in all, we should be
thankful for the fundamentals we see today on the heels of the Great Recession.
As 2012 unfolds and we see increased financial stability, the need for
companies to hire and the confidence of businesses to spend the $2 trillion in
cash hoarded over the past several years should increase. That said, commercial
real estate market fundamentals are poised to see strong rent increases.
Class B and C Improve
Class B and C markets
generally are not seeing the kind of returns realized in the institutional
market or with class A properties in top markets, but investors have been
expanding their search into tertiary markets and smaller cities looking for
higher returns and lower-priced assets. There is plenty of capital in search of
the right deal at the right price, as the issue is not liquidity, but pricing.
Class B and C properties
are starting to show improving fundamentals, with class A properties tending to
see peak pricing and rents, according to Reis. For example, B and C
experienced rental growth and positive absorption in 2011, although vacancy
rates have yet to decline. Tertiary markets are also beginning to show growth,
given that volume doubled in the first half of 2011 as compared to a year
earlier. In addition, office, apartment, and retail property transactions of
less than $5 million showed larger increases in volume than transactions
greater than $5 million during 3Q11 on a 12-month trailing basis, according to
CCIM members are seeing
this trend and believe that commercial real estate’s overall value is holding
its own as well, giving the asset a value versus price rating of 5.4 on a scale
of 1 to 10, with 10 being high, during 3Q11. As for the individual property
types, CCIM members rated the value of each sector equal to or higher than the
property price. As shown in Table 4, the apartment and industrial property
sectors have the highest value versus price ratings.
Despite the relative
stability of commercial real estate, there is risk with any investment,
particularly in periods of great uncertainty. As a result, we are seeing investors
turn to cash as the stock market turns
stomachs and bonds are priced for perfection. In fact, according to RERC’s 3Q11 Investment Trends
Quarterly survey of CCIM members, cash is the only investment type where the
ratings have consistently increased during the past year. As we saw with the
NCREIF and NAREIT Index readings in Table 1, commercial real estate is not
immune from economic risk — particularly when the rest of the market is going
haywire. It is difficult to quantify the amount of risk associated with
commercial real estate, but according to CCIM members, the return for commercial
real estate continued to outweigh its investment risk in 2011, even though the
amount of risk associated with commercial real estate continued to increase
throughout the year. By 3Q11, the return versus risk rating for this asset type
overall was 5.1 on a scale of 1 to 10, with 10 being high, indicating that the
return for commercial real estate was only slightly more than the risk.
Further, the apartment
sector was the only property type where the return versus risk rating increased
in 2011, while investment risk increased and outweighed the return for the
office, retail, and hotel sectors, as detailed in Table 4. The industrial
sector had a return versus risk rating of 5.1 in 3Q11, indicating a slightly
higher return than risk, but this return rating was down from 5.5 earlier in
the year. With a healthy score of 6.8, the apartment sector’s investment return easily
outweighed the risk.
The Outlook for Values
RERC forecasts aggregate
private commercial real estate values to continue to increase over the next few
expectation is bracketed by upside and downside scenarios that reflect a
projected value change between -1.0 percent and 6.0 percent in 2012, with the
current investment climate suggesting a higher probability to achieving the
upside scenario versus the downside scenario. Adding an income return of 6.0
percent, total returns in 2012 are expected to range from 5.0 percent to 12.0
percent, with the base-case scenario near 9.0 percent on an unleveraged basis.
It is important to note that RERC’s estimates are unleveraged, and the use of debt
has a compounding impact on value increases going forward. Thus, if positive
leverage is added to these estimates, one can see that commercial real estate
offers very attractive risk-adjusted returns for a core strategy.
Commercial real estate
entered this recession in better shape than in past recessions and did not need
to come clean on as many facets as other investments. In light of the turmoil
we see in the stock and bond markets, this forecast reflects the fact that commercial
real estate is delivering what investors thought they would get from the asset
class some 40 years ago — a hard asset that holds up in chaotic times, an
income stream that is relatively predictable when you truly analyze leases that
are in place, diversification when times are bad in the other investment
arenas, and some equity kicker with values increasing, especially when you add
some debt into the equation.
Kenneth P. Riggs, 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 email@example.com.