Investors don’t seem to mind.
by Kenneth P. Riggs Jr., CCIM, CRE, MAI, FRICS
‘Price 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 lower.
However, RERC expects values and prices to continue to increase as long as interest rates stay low. If RERC’s 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 Rates
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 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 compress.
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 compress.
A Closer Look at the Property Types
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 couple years.
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 fundamentals.
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 2015
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 offers.
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.
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