From the depths of the Great Recession, up was the only avenue. Commercial property values soared behind easing monetary and fiscal policy, boosted by an expansion that touched every part of the economy. But that wasn’t the surprise. Commercial real estate’s durability during this recent period of market uncertainty and escalating trade tensions certainly continues to astonish industry and investment observers.
While marveling at its past, they now must ponder its future as traditional portfolios search for the protection real estate may offer.
The historical trend line north
From rapid acceleration to modest incrementalism, commercial real estate values have been consistently headed higher since late 2009. In today’s “slowing, but growing” economy, which sports the lowest unemployment rate in over five decades, growth has remained resilient. Other contributors to the trajectory include the return of lower interest rates, solid commercial real estate fundamentals, and a firm supply and demand backdrop. There’s also an overwhelming supply-demand disconnect on the investment side, with abundant dry powder in private equity chasing deals.
For example, 10 years into this expansionary cycle, property prices rose 1.1 percent month-over-month back in May, the biggest monthly gain since early 2015.1 And while we see some stratification in growth between sectors (think industrial at the top and retail at the bottom), year-over-year pricing recently rose 7.2 percent.1
A transition as 2019 comes to a close
The first half of 2019 saw year-over-year cap rates increase just 24 basis points on average for properties solid in major metros, and 22 basis points for properties sold outside of those areas.1 That’s negligible with prices still climbing, leading most observers to conclude that net operating income growth was keeping pace with price increases through strong occupancy and rent growth, in turn holding cap rates in place.
We are also seeing continued sector stratification at the top and bottom of the markets. Take a look at the short- and medium-term growth in manufactured housing, industrial, and even student housing compared to the precipitous decline in malls.
We could also be moving towards a pricing plateau in some markets due in part to a lingering bid/ask gap. Buyers are being cautious late cycle – they are willing to take on risk but expect to be paid for it. There’s also a lot of inventory in need of substantial CAPEX for re-leasing, particularly in the office sector, as corporate companies shift priorities and re-tool in preparation for the next downturn. Declining Treasury yields and lower mortgage rates could support some further appreciation, but the storm clouds on the horizon will likely keep the lid of anything but modest short-term growth.
Macro and micro forecasts paint picture of moderation
Despite warning signs from other global economies, as well as trade policy uncertainty, we believe a strong U.S. consumer will insulate the economy on our shores from a return to 2008. Markets, meanwhile, seem to have competing views of the current situation. Bond yields continue to fall, a risk-off rush that seems to indicate economic fragility and the heightened expectation of future Federal Reserve intervention. Yet, equity markets are on pace for a strong 2019, and despite an uptick in sentiment-driven volatility, no signs of significant dislocation promote short-term confidence.
A shallow and brief contraction would likely only dent real estate values, leaving their long-term future in the hands of fundamentals. We are seeing some cracks at the surface, but nothing foundational beyond a typical mature real estate cycle. Rent growth across property types is mostly restrained, development is not rampant but is weighing on rent growth, and sector stratification continues its recent narrative.
The bottom line is that modest economic growth around two percent plus 1-to-1.5 percent supply growth likely limits market revenue per available square foot for most property types to inflationary-like two percent gains over the next five years, according to Green Street Advisors. Exceptions that follow the current trend are industrial to the upside and malls to the downside. Many property types will still generate solid NOI in the short term, but the economic tailwinds of the last decade will start to weigh down that growth.
Will real estate deliver expected returns for late-cycle portfolios?
Historically, real estate seeks to deliver unlevered returns 200 basis points higher than Baa 30-year corporate bonds. Green Street’s forecast indicates a 6.1 percent unlevered return for commercial real estate compared to 3.8 percent for long-duration bonds – a 230-point difference. Commercial real estate also aims to outpace high yield bonds, and Green Street again forecasts success with a 6.1 percent to six percent comparison.2 At least according to Green Street, real estate will hit its mark – even in a mature real estate cycle.
The current public-private price disconnect could help foreshadow those returns. Investors buying and selling at net asset value should pay attention to relative gross asset value. According to Green Street, the metric has historically been predictive of near-term changes in private market pricing.
As Treasury yields continue to fall, commercial real estate’s current mid-five percent cap rate may look very attractive to income-focused investors. A higher-than-historical spread to the risk-free rate plus lower mortgage rates may fuel one last push higher in property prices, but economic uncertainty restricting the flow of capital may make any spike short-lived, leading pricing to an equilibrium of moderation.