Investors don’t seem to mind.
is what you pay; value is what you get.”
— Warren Buffet
As we look to 2015 and
beyond, the commercial real estate market is enjoying much positive press and
continues to be a favored asset class relative to stocks, bonds, and cash.
After the most recent commercial real estate downward cycle in third quarter 2008,
followed by a rebound in 1Q10, we are at a new crossroads where prices are
clearly outpacing valuations. This is the final phase of our up cycle, and the
key question is, how long can this phase run? When we think about investments
and investment cycles, we are coming to realize that the more things change,
the more they stay the same. In other words, be worried when the market starts
to say, “This
time it is different.”
Economic Fits and Starts
In our search for how
prices and values are aligning themselves, we first need to examine the
economy. The outlook for the U.S. economy is much brighter than it has been
since before the Great Recession. Besides more than 3 percent growth in gross
domestic product in 2Q14 and 3Q14, inflation remains low and the unemployment
rate declined to 5.8 percent in October 2014. In fact, job growth has improved
enough that employers are on pace to add the most jobs on an annual basis since
1999, according to the Bureau of Labor Statistics.
However, a variety of
headwinds is still holding back the progress that many economists had been
predicting, with each setback causing forecasters to recalibrate their
expectations. These recalibrations have been triggered by a workforce
participation rate that has declined to 1978 levels, as the wages of the
majority of workers remain relatively stagnant. In addition, the federal debt
has ballooned to nearly $18 trillion, while major entitlement programs are
underfunded. The housing sector has improved slightly, but the young adults we
have relied on in the past to purchase homes are burdened with oversized
amounts of student debt. Furthermore, many of the economies in Europe and Asia
are contracting, and territory disputes from the Ukraine and Russia to Iraq and
Syria have given rise to new acts of terrorism. However, in the end, the U.S.
economy appears to have many resilient elements in place to withstand future
disruptions in the financial markets.
Each quarter, Real Estate
Research Corp., a Situs company, surveys some of the nation’s leading institutional investors about the economy
and reports this information in the quarterly RERC Real Estate Report. As
demonstrated in Figure 1, commercial real estate has been consistently rated
higher than the alternatives, even as the economy has been recovering.
Flush With Liquidity
Despite the macroeconomic
uncertainties, the global and domestic markets have provided investors more
capital than they know what to do with. With investors searching for a place to
park this capital (with good risk-adjusted and safe returns), the result has
been asset prices pushed to all-time highs — which is making the market
nervous. We see this in the stock market, with record-high performance, and we
see it with commercial real estate, which, with its attractiveness as an asset
class, including return performance, ability to hedge against inflation, and
tangible nature, has attracted a great deal of capital.
Put stocks and real estate
together and you get an idea of just how much in demand these two asset classes
are. According to Bloomberg, investors are rewarding retailers’ efforts to spin their properties into real estate
investment trusts. Sears Holdings recently announced plans to create a REIT for
its properties, and shares increased 31 percent.
RERC also examines the
amount of capital available for investment and compares it to the underwriting
discipline. As shown in Figure 2, investor ratings for capital availability
have greatly outpaced the discipline (or underwriting standards) for capital in
3Q14. It is worth noting that the last time the availability of capital
outpaced discipline to this degree was in 2Q07 — shortly before the credit
crisis that preceded the Great Recession.
The comparison of the
availability and discipline of capital shows that we are again at an inflection
point. The flood of capital chasing commercial real estate continues to
pressure property prices to increase, especially for high quality assets in top
markets. Some investors have noted that, given high prices, there is already too
little product to invest in, which further drives prices higher and returns
However, RERC expects
values and prices to continue to increase as long as interest rates stay low.
history of availability of capital versus the underwriting discipline holds up,
this bull commercial real estate market has another 18 to 24 months to run.
This is not to say the market is right, but it is the market.
It All Depends on Interest
Although the Federal
Reserve has concluded its recent quantitative easing program, monetary policy
remains accommodative, with the federal funds rate remaining at 0 percent to
0.25 percent for “a
considerable period of time.” The Fed’s
target unemployment rate has been reached, but its target inflation rate is
elusive, and growth remains slower than expected.
The market and most
investors anticipate that the Fed will raise short-term interest rates in
mid-2015, stating that it is too risky for the Fed to leave rates at current
record lows much longer (in case the rates need to be lowered again when there
is another recession). Others believe that the Fed will leave the funds rate
very low for several years due to global pressure, as troubled economies in the
rest of the world would be forced to pay higher interest rates.
As shown in Figure 3,
risk-free rates in other developed economies have followed the U.S. trend to
keep rates low, and as shown in Figure 4, 10-year Treasury rates have been
declining for several decades. Despite the Fed’s clear message about their intent to increase U.S.
Treasury rates at some point, some investors have become complacent, expecting
Treasury rates — as well as interest rates — to stay low for much longer.
Continuing low interest rates will be another significant benefit for
commercial real estate investors.
Value vs. Price
As long as Treasury rates
and interest rates remain low, the global investment environment for commercial
real estate will be very attractive. Investors will continue to purchase real
estate, prices will continue to increase, and values will continue to chase
prices, as capitalization rates on a broad market perspective will further
As shown in Table 1, RERC’s value vs. price rating for commercial real estate
overall dipped slightly to 5.3 on a scale of 1 to 10, with 10 being high,
during 3Q14. However, with the midpoint of the rating scale at 5.0, a rating of
5.3 indicates that value vs. price can still be found in commercial real estate
overall, despite the slight decline in this rating during the past few quarters.
On a property sector
basis, the value vs. price rating increased for each of the sectors (except for
the hotel sector) during 3Q14. As shown, the industrial sector retained the
highest value vs. price rating among the property types. However, all sector ratings
were higher than the midpoint of 5.0, which means that prices still have room
to climb before properties become overpriced (compared to their value) — at
least as long as interest rates remain low and cap rates have room to further
A Closer Look at the
As 2015 continues, commercial real estate investors are encouraged to keep in mind the following points:
- The U.S. economy is resilient and will survive a looming short-term rate correction. In the long term (toward the end of the decade), the economy is positioned to demonstrate above-average growth.
- Global pressures will continue to keep 10-year Treasury rates below 3.0 percent in 2015.
- Commercial real estate will be a preferred asset class in 2015 relative to stocks, bonds, and cash, and this will continue to put upward pressure on prices and values throughout the U.S.
- Commercial real estate space fundamentals will continue to improve slightly, except in the multifamily sector, where vacancy is increasing due to supply additions.
- Required total returns and capitalization rates for the broad commercial real estate market will continue to compress in 2015, as long-term interest rates stay low.
- RERC’s total return expectations based on our value forecast and income forecast reflect a total return in the low teens for unleveraged commercial real estate assets, and a total return in the mid-teens on a leveraged basis for 2015.
- An increasing number of alternate property types (beyond the core property types) will continue to attract investors, including storage facilities, single-family housing, student housing, seniors housing, and medical office buildings.
- There will be continued expansion of investment products and opportunities for retail investors through private real estate investment trusts, single property-REITs, club investing, and defined contribution options.
- The market cycle is not different this time, but commercial real estate will see another strong year in 2015, only to be faced with another market down cycle looming out past 2015.
Office. The office market
continues to struggle. The vacancy rate was 16.8 percent in 3Q14, which was
only 10 basis points lower than a year ago, according to Reis. Despite that,
effective rents increased 2.7 percent to $23.94 per square foot year over year.
In addition, according to Real Capital Analytics, 12-month trailing transaction
volume increased more than 27 percent to $121 billion in 3Q14 compared to the
previous year, and prices psf increased by 6 percent to $245. RERC’s required pre-tax yield rate (internal rate of
return) dipped to 7.9 percent, and the required going-in cap rate decreased to
6.1 percent in 3Q14. Figure 5 illustrates the spreads between RERC’s required pre-tax yield rates and going-in cap
rates and 10-year Treasurys. Vacancy is expected to drop to 16.3 percent and
rents to increase 3.7 percent by the end of 2015, according to Reis. Some
metros are expected to outpace expectations, such as Portland, Ore., with
stagnant cap rates in the office market, and Minneapolis, which is expected to
see slightly higher rental growth than the national average over the next
Industrial. Vacancy in the
industrial sector decreased to 9.0 percent in 3Q14, according to Reis, and was
accompanied by effective rental growth of 2.5 percent YOY to $4.45 psf.
Transaction volume increased by 6.0 percent, with prices increasing 17.3 percent
to $77 psf over the past year, per RCA. RERC’s required pre-tax yield rate for the industrial
sector declined to 7.7 percent, while the required going-in cap rate decreased
to 6.0 percent in 3Q14. Reis forecasts the industrial vacancy rate to decline
to 8.0 percent by 2016, and for effective rent to grow by 3.3 percent.
Industrial vacancy is expected to decline even more in some markets, such as
Sacramento, Calif., and Orlando, Fla.
Multifamily. The vacancy
rate for the apartment sector increased slightly in 3Q14 to 4.3 percent, while
the effective rent rose 3.91 percent during the past year to $1,117 per unit,
according to Reis. As reported by RCA, 12-month trailing transaction volume
increased 6.2 percent YOY to $104 billion in 3Q14, as the price increased 21.5
percent to $128,259 per unit, a new high. RERC’s required pre-tax yield rate declined to 7.0
percent, while the required going-in cap rate declined to 5.0 percent. Reis
notes that due to expected completions of 444,000 units over the next two years,
vacancy is likely to increase to 4.9 percent in 2015 and to 5.1 percent in
2016, although vacancy in some metros (San Diego, for example) is not expected
to increase as much. Effective rental growth of 3.1 percent in 2015 and 2.6
percent in 2016 is expected.
Retail. According to Reis,
retail vacancy declined slightly to 10.3 percent in 3Q14, while effective rent
increased 1.91 percent to $17.07 psf. Transaction volume increased 8.1 percent
YOY, with pricing increasing 24.8 percent to $214 psf, as investors have been
purchasing higher quality retail properties. RERC’s required pre-tax yield rate decreased to 7.8
percent in 3Q14, while the required going-in cap rate declined to 6.1 percent,
although this has had more to do with abundant capital and easier financing
than improving fundamentals. However, Reis projects that vacancy will be 100
bps lower at 9.3 percent and rents will step up to 3.3 percent annual growth in
2016. Retail properties in some metros — especially Florida markets like Miami
and Orlando — offer strong investment opportunities due to improving
Hospitality. Smith Travel
Research reports that U.S. hotel occupancy rose 3.9 percent YOY to 62.7 percent
during the week of November 9-15, 2014. Revenue per available room and the
average daily rate increased 8.6 percent to $72 and 4.6 percent to $115,
respectively, according to PKF Hospitality Research. Hotel volume increased to
$33 billion on a 12-month trailing basis in 3Q14, according to RCA, while the
price per unit increased to $154,798. RERC’s required cap and discount rates for this sector decreased more than
for any other property type on a YOY basis in 3Q14, as RERC’s required pre-tax yield rate and required going-in
cap rate declined by 80 bps to 9.2 percent and 7.2 percent, respectively. PKF
predicts that hotel sector occupancy will reach 65 percent in 2015, which would
be the highest occupancy achieved since the recording of this rate started.
Investment trends for hotel properties seem to be moving further out from core
urban areas for example, Long Island, N.Y., versus Manhattan.
Value Expectations for
Commercial real estate is
a favored investment alternative compared to stocks, bonds, and cash,
especially in these uncertain times. Not only does commercial real estate
generate high risk-adjusted returns compared to other investments, property is
tangible, transparent, a hedge against inflation, and offers reasonable return
performance on capital and income. (Income is currently approximately 60
percent of returns.)
Commercial real estate has
more than recovered the value it lost in the Great Recession, as shown in
Figure 6, and with respect to return performance, broad market prices and
values have room to grow for approximately 12 to 18 months. This does not mean
that commercial real estate prices and values are sustainable, but for many
investors, there are no other good alternatives, and as a result, many investors
will continue to pay nearly any price for the value commercial real estate
Kenneth P. Riggs Jr., CCIM, CRE, MAI, FRICS, is president and CEO of Real Estate Research Corp., a Situs company, and publisher of the RERC Real Estate Report.
For more information, or for a special CCIM member discount to the report,
please contact RERC at firstname.lastname@example.org.