Market forecast
Changing Conditions
Understanding commercial real estate's shifting dynamics is the key to success this year.
By Kenneth P. Riggs, CCIM, CRE, MAI |
The U.S.
economy, while remaining relatively strong, is facing greater challenges than
it has seen in more than two decades. Volatile energy prices, a slowing housing
market, consumer spending shifts, geopolitical risks, natural disaster recovery
costs, inflation, and increasing interest rates are just a few of the factors
now affecting the U.S. economy.
And as the economy goes, so goes commercial real estate.
Market performance increasingly is becoming dependent on the overall economy's
strengths and weaknesses. Economic growth of 3.0 percent to 3.5 percent is
predicted into 2006 along with a population increase of approximately 2.5
million and some 2 million new jobs. For the last several years, consumer
spending has fueled the economy, but this tide is shifting. With higher energy
costs and increasing interest rates, consumer spending is starting to drag, and
businesses are beginning to provide fuel for economic growth. The remainder of
this decade will be marked by job growth as a key ingredient in allowing
commercial real estate fundamentals to strengthen, which translates into improved
property earnings.
This updraft for commercial real estate markets is coming
at a critical juncture. The markets have been paid a great favor in the form of
low interest rates, which came at a time when commercial real estate could take
full advantage of them. Commercial real estate finally was poised as a
credible, mainstream investment while alternative investments offered
relatively lower risk-adjusted returns. As a result, investors decided to
allocate much more capital to this asset class.
This confluence of factors sets the stage for commercial
real estate returns to come under the greatest level of compression in recent
history, and it is unlikely that this will repeat itself in the foreseeable
future. Across the board, required capitalization and discount rates have
declined by some 200 basis points, or more than 20 percent, since first quarter 2001. Understanding the profound shift that the
capital markets have experienced and the future direction of cap rates and
discount rates is the new key to success for transaction brokers, advisers, and
investors. This skill falls under risk identification, risk management, and
risk diversification.
With the economy and the financial markets as the
backdrop to this year's commercial real estate forecast, it's important to
analyze market fundamentals relative to capital market dynamics to develop a
return performance outlook for each of the major property types and forecast
the property sectors that should provide the best relative performance in the
coming months.
Cap Rates and Returns
Total realized returns for commercial real estate have
outpaced the stock and bond markets on a risk-adjusted basis. This is reflected
in Table 1, which compares stocks, bonds, and commercial real estate from an
absolute return perspective. Commercial real estate's realized return has shown
the most relative strength during the past year, outpacing other investment
alternatives and providing a high relative real rate of return (total return
less inflation).
Table 1's total realized commercial real estate returns
should be compared to market expectations that look at required total returns
and cap rates. Required total returns and cap rates that get deals done today
are significantly lower than historical levels and the level of realized
returns. Table 2 provides an overview of required cap rates and total returns
for commercial real estate on an unleveraged basis. If an investor leveraged
these returns by capitalizing the deal structure with debt, the level of return
would increase accordingly, given that positive leverage still exists on a
total return basis.
This outsized realized return performance has been a
result of the capital markets' dynamics where required return expectations have
been reduced significantly, including commercial real estate return
requirements on both absolute and risk-adjusted bases, which is referred to as
rate compression. The reduction in required returns allows values and prices to
increase significantly even if the property's income is not increasing, which
then results in very high realized or reported returns. However, this level of
realized or reported performance is not sustainable as required returns will
stabilize and value increases created by cap rate compression also will end.
Table 2 demonstrates commercial real estate's relative
attractiveness in an environment where required cap rates and total returns on
an unleveraged basis are historically low. Third-quarter 2005 going-in cap rates range on average from 6.4 to 7.8
percent for office, industrial, retail, and multifamily and 8.7 percent for
hotel properties, while total unleveraged required returns or yields range from
8.3 to 9.4 percent for core assets and 11.3 percent for hotels. Suffice it to
say, commercial real estate's realized or reported return performance in both
public and private markets has been nothing short of spectacular relative to
the stock and bond markets.
This compression, or lowering, of required returns is
what has given the lift to values and prices for commercial real estate. If the
net operating income stays the same but cap rates and total yield requirements
are lower by 200 basis points, then values and prices will increase 25 percent
over that period. (Averaged over three years for an annual net appreciation of
8 percent and add a cap rate of 8 percent, the total unleveraged returns are
roughly 16 percent. Add positive leverage to this simple math and leveraged
total returns or yields rise to around 25 percent.)
This leads us to the question: How long can the good times
last? The short answer is they cannot continue for much longer, particularly as
the Federal Reserve Board increases short-term interest rates and long-term
rates finally respond to existing imbalances. Commercial real estate is, and
has been for the past couple of years, in an over-performance phase of its
investment cycle. Real Estate Research Corp. analyzes commercial real estate's
investment performance cycle by comparing the historical difference between
realized or reported returns and investors' required or expected returns. It
then assesses where a property is located within its investment cycle in
relation to a market equilibrium point in which reported returns equal investor
required returns. Reported or realized returns started to outpace required
returns in early 2003. This continues to hold true, but for how long? This
dichotomy puts investor expectations at risk.
Right now investors, brokers, and advisers continue to be
happy, and they should be - commercial real estate has been one of the best
places to be during the past several years. This happiness has been well earned
by the industry through transparency, liquidity, and prudent investment
practices. While all good things must come
to an end, there is no bubble in the
commercial real estate industry, and there will be no abrupt pop.
Property Market Outlook
Office and hotel returns have been held down during the
last few years in an economy that was growing but characterized by higher
productivity, fewer new jobs, and business spending that was not keeping a
relative pace with consumer spending. However, with businesses growing, the
tide is shifting for both of these property categories. Offices and especially
hotels are expected to have the strongest prospects for revenue growth while increasing
their relative occupancy levels this year. This will translate into improved
pricing power and earnings for these properties. Clearly we have seen
well-leased and premier properties fetch record-breaking prices; however, this
year should bring a broader market recovery in sales and prices for both
offices and hotels. Their risk profiles reflect higher cap rates and total
return requirements, and they are well deserved. As such, this is a great time
to refocus on hotel and office investment opportunities.
With consumer spending being the stalwart of the economy
during the last few years, retail investments have delivered the strongest
returns among the major property types. Retail investments have regained the
credibility they possessed in the late 1980s, especially high-end regional mall
properties. In the early 1990s, the retail industry transformed itself with
savvy, predatory businesses serving a consumer environment dominated by
two-wage households that had plenty of discretionary dollars. This year,
however, consumers will face more challenges than they have seen in decades.
Higher interest rates signal the end of using houses to finance expenditures,
higher energy costs are starting to eat away at discretionary spending, and it
will be time for consumers to pay down their credit cards. Nevertheless,
approximately two-thirds of the U.S.
economy is driven by consumers. Employment will be strong in 2006, and we are a
financially robust society. Cap rates for the retail sectors range from 6.7
percent to 7.0 percent with total yield requirements of 8.3 percent to 8.8
percent. The bottom line: Retail fundamentals are reasonably strong, but do not
expect the level of realized returns seen in the past several years for this
property type this year.
Apartment returns have been extremely favorable due to
their perceived risk profile and the changes that have taken place in the
residential markets, particularly condominium conversions. Required returns for
apartments are some of the lowest among all of the core property types, with
cap rates of 6.4 percent and total return expectations of 8.3 percent on an
unleveraged basis. They are priced for perfection. The demand fundamentals look
promising for this sector, as job growth is very favorable to this property type
and rising interest rates will push some hopeful home buyers back into the
rental market. But as is always the case for multifamily, the supply side of
the equation poses risk to the overall balance of the fundamentals. On a
risk-adjusted basis, apartments will continue to be highly sought-after
investments and will provide low but solid returns.
Industrial warehouses have provided the most stable
returns among the core property types. Investors are regaining the confidence
they once had for this sector, but it was only a few years ago that the
national industrial vacancy rate jumped higher than 10 percent and the industry
experienced negative net absorption. Investor confidence clearly resonates with
going-in required cap rates of 7.0 percent for warehouse and total required
unleveraged returns of 8.5 percent. Industrial research and development
investments carry a greater level of risk relative to warehouse. This is
reflected in the return requirements with a cap rate of 7.8 percent and a total
yield requirement of 9.4 percent. Both of these investments are good prospects
this year, as there should be upward pressure on NOI levels and the risk
profile should not be drastically altered, thereby providing investors with a
solid risk and return opportunity.
Investment Climate
Looking ahead, this is a tipping point for commercial
real estate where the favorable capital markets providing a boost in values and
prices through low interest rates will give way to the challenges of the
economy, and subdued consumer spending will be offset by more business
spending. As this shift occurs, market factors, or demand relative to supply,
will be the focus in pursuing solid real estate strategies. Property earnings
will take the front seat in driving value versus cap rates, which have driven
up values and prices. But this shift will not be as universal in supporting
values and prices as was the cap rate compression era. Hotels and offices will
start to deliver stronger returns relative to the other property types. However,
both cap rates and total returns are forecast to be lower for all core property
types. There is not likely to be an abrupt shift in investor attitudes toward
commercial real estate - this is not a bubble - but this will be a year in
which the market searches for more sustainable levels of returns.