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The State of Commercial Real Estate is Strong … If You Know Where to Look

You assess the lay of the land: construction is happening all around you. News bulletins are discussing promising GDP or an expectation-shattering jobs number. Buildings are rising from vacant turf, and those constructing them are making more money.

Commercial real estate appears strong, but will that be the case a year or two from now? Investing in commercial real estate isn’t as much about today as it is turning patterns and forecasts into sound investment decisions for tomorrow. We concur that the state of commercial real estate is strong if you invest prudently and avoid broad generalizations.

Macro moderation

3.2 percent GDP growth in Q1 came as a surprise to many – especially after the late-2018 talks of slowing growth sent many investors out of equities. Yet, one quarter a year does not make. Moderation is still the word of choice, as 2018’s 2.9 percent growth is expected to recede over the next five years into a “sleepy” 2 percent territory, just as the impact of government spending and tax cuts fade.

Job growth continues at a surprisingly consistent clip with 275,000 jobs added to the private sector in April, the highest increase since July 2018.1 The largest drivers of hiring came from professional/business services and education/health services.

Yet, a consensus seems to be forming that the growth was more the recovery’s parting shot, not a second wind. While wages and available workers already indicate that the labor market is tight, demographics are adding a few screws to the vise. The United States is aging – with a precipitous decline in the working age population over time. Soon, there will be a labor force shortage.

From the macro to the markets, fears of an impending recession have receded. The trade war with China may be nearing its end, and the Federal Reserve has paused its rate tightening plan for the time being. By avoiding cherry-picked data, it appears growth is moderating, which will moderate hiring – just as the available labor force, you guessed it, moderates.

This impacts demand for real estate just as supply is ramping up. Supply growth in apartments, industrial, office, and lodging is at or above long-term norms, even in gateway markets where construction has been historically subdued.2

Fizzling fundamentals

Masked by Wall Street euphoria, real estate fundamentals have been slowing for some time. We classify them as muted and mature, a typical description that should alter any investing strategy from a focus on appreciation to one on cash flow.

Market RevPAF (revenue per available foot) is a single measure that combines changes in market-level occupancy and rent. After several years of slow declines, this metric is projected to stall at 1 percent through 2023 – far off the 7 percent weighted average from 2007.2

There are some notable exceptions. Industrial, manufactured homes, and senior housing are all being boosted by secular shifts in supply and demand. Industrial demand has exploded with the rapid growth of ecommerce, while manufactured homes are an affordable option for would-be homeowners who are typically priced out of the housing market. As noted earlier, the U.S. is aging, and these Boomers are opting at increasing frequency for the comfort and convenience of assisted living facilities.

Meanwhile, core sectors like office and retail may struggle. Office supply is growing, especially in some gateway markets, and co-working is forcing a re-pricing of risk. Retail is being hit even harder by ecommerce growth and a shift in consumer spending habits from goods to services and experiences.

Varying valuations

Historically, buy-and-hold real estate is priced to exceed long-term, Baa corporate bond yields by about 150 basis points and match high-yield bond yields. Following the Q4 2018 selloff, high yield has rallied, improving the outlook for commercial real estate pricing. We see real estate fairly priced vs. high yield, but modestly overpriced compared to corporate bonds.

The public market is also offering strong signals. The premiums or discounts at which REITs trade relative to the underlying value of their properties has typically foreshadowed future changes in private market values. In fact, property types that historically trade at the largest premiums in the public market often outperform over the near term in the private space. Yet, it’s important to note that REITs trading at a slight premium to net asset value is an oddity for this stage of the real estate cycle, which may indicate that public markets will eventually reset to private markets, not vice versa.

Investing intelligently with an eye on tomorrow

Demand drivers are slowly deteriorating from highs just as an influx of supply hits. This will further dampen already muted real estate fundamentals, forcing managers to move away from a return strategy focused on appreciating building values. Managers may also search outside core corporate sectors like office and retail, while strategically playing the public markets to avoid a cap on near-term upside.

1 ADP National Employment Report. 4/19.

2 Green Street Advisors. March 7, 2019 Commercial Property Outlook. 3/19.

Resource Securities LLC, Member FINRA/SIPC.

Resource has two interval funds that are distributed by ALPS Distributors, Inc. (ALPS Distributors, Inc. 1290 Broadway, Suite 1100, Denver, CO 80203). Resource Alternative Advisor, LLC, Resource Real Estate, LLC, their affiliates, and ALPS Distributors, Inc. are not affiliated. In addition, Resource Real Estate, LLC is also the sponsor of several non-traded REITS.

The information contained herein is intended to be used for educational purposes only and does not constitute an offer to sell or a solicitation to purchase securities. Such offers or solicitations can only be made by means of a prospectus. Prior to making any investment decision, you should read the applicable prospectus carefully and consider the risks, charges, expenses and other important information described therein.

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The value of your investments may decline, and you could lose some or all of your investment. The prospectus can be obtained by contacting your financial advisor or by visiting our website at www.ResourceAlts.com.

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Resource is the marketing name for Resource Real Estate, LLC, Resource Alternative Advisor, LLC, and their affiliates. Resource may distribute certain products through Resource Securities LLC, a wholly owned broker/dealer, Member FINRA/SIPC

 

The information contained herein does not constitute an offer to sell or a solicitation to purchase securities. Such offers or solicitations can only be made by means of a prospectus. Prior to making any investment decision, you should read the applicable prospectus carefully and consider the risks, charges, expenses and other important information described therein. The value of your investments may decline, and you could lose some or all of your investment. To obtain a prospectus containing this and other information, please call (866) 773-4120 or download the file from www.ResourceAlts.com. Read the prospectus carefully before you invest.

 

Resource has two interval funds that are distributed by ALPS Distributors, Inc. (ALPS Distributors, Inc. 1290 Broadway, Suite 1100, Denver, CO 80203). Resource Alternative Advisor, LLC, Resource Real Estate, LLC, their affiliates, and ALPS Distributors, Inc. are not affiliated.

 

Performance data quoted represents past performance. Past performance is no guarantee of future results and investment returns and principal value of the Fund will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance data quoted above. For performance information current to the most recent month-end, please call toll-free (866) 773-4120 or visit www.ResourceAlts.com.

 

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