by Kenneth P. Riggs Jr., CCIM, CRE, MAI
As investors dealt with so much fiscal uncertainty in 2013 — the budget deficit, potential tax increases, raising of the debt ceiling, and higher health insurance premiums associated with the Affordable Care Act just to name a few — it is almost a relief to get back to worrying about the basics. Concerns such as the economy, capital markets, and monetary policy, as well as geopolitical challenges, have taken a back seat in news reports and day-to-day conversations.
Even so, as investors search for alpha, or above-average expected returns in their real estate holdings, questions remain as they seek to balance their appetite for returns versus their apprehension of risk. Have the Federal Reserve’s extremely accommodative policies created asset price inflation in the commercial real estate market? Are we looking at a potential correction or potentially lower returns? Are we facing another inflection point for commercial real estate or will property values continue to appreciate and provide good annual returns? Which property types and locations have the most opportunity for solid returns in this uncertain climate? Is the risk systemic?
Capital Continues to Flow
Although the U.S. has seen generally positive economic traction since the recovery began, growth continues to stumble along, with little inspiration beyond the addition of the various forms of quantitative easing, including very low short-term interest rates incorporated by the Federal Reserve. Even so, Real Estate Research Corp.’s institutional investment survey respondents projected that the economy would grow at a rate of approximately 2.4 percent in 2014, which is only slightly lower than the 2.6 percent growth projection that the International Monetary Fund issued for the U.S. economy.
In addition, some investors have noted that there is more capital available than solid product in which to invest, and as such, pricing has become quite aggressive for certain top-tier properties in the major markets. Further, as investors’ appetite for returns increases, their willingness to take on a little more risk has been increasing, and we are seeing increasing amounts of capital available for properties in secondary and tertiary markets.
While the availability of capital continues to increase for such properties, the gap between the availability and discipline of capital has been widening. As shown in Figure 1, the availability of capital rose to 7.6 on a scale of 1 to 10, with 10 being high, while the discipline of capital was rated at 6.4, as reported in the 3Q13 RERC Real Estate Report.
Despite repeated reassurance from the Federal Reserve about keeping interest rates low, the fragile markets were taken aback last spring when the Fed first introduced its plan to eventually begin tapering its qualitative easing program. The stock market sank and 10-year Treasury yield rates nearly doubled as investors faced a riskier future. Although the stock market has improved considerably since that time and the major indices have reached new highs, 10-year Treasury yield rates have been steadily increasing, indicating continued risk in the market.
During 3Q13, the 10-year Treasury rate increased 70 basis points to 2.7 percent, which is the fourth consecutive quarter of increases since its historic low in 3Q12. Figure 2 presents the spread between RERC’s required pre-tax yield rates, or internal rates of return, and 10-year Treasurys and also the spread between RERC’s required capitalization rates and 10-year Treasurys. Given the significant increase in the 10-year Treasury rate, the spreads for both the pre-tax yield rate and going-in cap rate over Treasurys have declined to 570 basis points and 400 basis points respectively. Although the spreads have been declining, they are still near their 10-year averages, showing the continued attractiveness of risk-adjusted returns for commercial real estate.
What Are the Trends Showing?
For the most part, commercial real estate investment trends have continued to improve over the past year, although the improvements have been achingly slow. RERC anticipates fundamentals to continue to make measured progress in 2014, in keeping with the slow-growing economy and sluggish job growth, while future risk appears to be primarily associated with increasing fiscal and political maneuvering related to the fall 2014 election.
In general, transaction volume has increased during the past 12 months, with total volume increasing approximately 25 percent on a year-over-year basis to $89.7 billion in 3Q13, according to Real Capital Analytics. Vacancy has decreased slightly for all property types in 2013 as absorption has increased and new construction was minimal, except in the apartment sector, while rents have increased only slightly according to Reis.
From the standpoint of returns, RERC’s required pre-tax yield and going-in and terminal cap rate expectations have continued to decrease in 2013, although they appear to have stabilized somewhat during the last few quarters as depicted in Figure 3. The “All Property Types Average” required pre-tax yield rate and required going-in and terminal cap rates for unleveraged properties further stabilized in 3Q13. RERC’s return expectations have nearly reverted to levels experienced before the credit crisis and Great Recession.
Office. With positive absorption throughout the year, the national office sector’s vacancy rate declined to 16.9 percent in 3Q13 from 17.2 percent a year earlier, according to Reis, and effective rents increased to $23.32 per square foot, an average of 2.3 percent for the year. Total office transaction volume for third quarter was $24.5 billion, a 36-percent increase over the previous year’s volume, per RCA, while the average price increased 12 percent to $233 psf. However, RERC’s average required pre-tax yield rate (discount rate) for unleveraged office properties declined to 8.1 percent in 3Q13, while the required going-in and terminal cap rates decreased to 6.5 percent and 7.2 percent, respectively. As for 2014, Reis projects the vacancy rate to continue to improve, declining to 16.5 percent by the end of the year, and for rental rates to increase 3.4 percent.
Industrial. The availability rate for the industrial sector declined to 11.7 percent during 3Q13, according to CBRE. This was a 30 basis point decline from the previous quarter and a 130 basis point decline from the previous year. According to Newmark Grubb Knight Frank, asking rents for industrial properties increased to $5.72 psf in third quarter. Transaction volume for the industrial sector increased to $14.2 billion in third quarter, a 70 percent increase from 3Q12, while the average price inched up slightly to $65 psf, according to RCA. RERC’s required pre-tax yield rate for unleveraged industrial properties remained flat at 8.1 percent in third quarter, and the required going-in cap rate fell 20 basis points to 6.5 percent as the required terminal cap rate held steady at 7.2 percent. Although absorption is still outpacing completions, both are expected to increase in 2014, according to NGKF data, and asking rent is projected to increase to $5.95 psf.
Retail. Positive absorption continued for the neighborhood/community retail sector, with the average vacancy rate dipping to 10.5 percent in 3Q13 from 10.8 percent in 2012, according to Reis. Effective rents increased to $16.74 psf, which was up only 0.4 percent for the quarter and 1.4 percent YOY. In addition, retail property transactions increased by approximately 25 percent to $19.2 billion in 3Q13, and more than doubled during the past year, according to RCA. Although the average price of retail space declined slightly to $170 psf in 3Q13 from the prior quarter, this was a 13.0 percent increase over year-ago prices. RERC’s required pre-tax yield rate for unleveraged retail properties increased slightly to an average of 8.0 percent in 3Q13, as the required going-in cap rate fell slightly to 6.4 percent and the required terminal cap rate increased 20 basis points to 7.1 percent. In 2014, neighborhood/community retail vacancy is expected to decline to 10.1 percent and effective rents should increase 2.2 percent on an annual basis, per Reis.
Multifamily. With 123,518 completions in 3Q13 — the highest amount since 2009 — the vacancy rate for the apartment sector still managed to decline to 4.2 percent in third quarter from 4.7 percent a year ago, according to Reis. Effective rent growth increased 3.2 percent on an annual basis to $1,074 per unit in third quarter. Although transaction volume increased about 20 percent to $22.1 billion in 3Q13 from the previous quarter, volume was down 20 percent from year-ago figures, according to RCA. In addition, the price for apartment properties has been inching downward over the past year to an average of $107,240 per unit in 3Q13. RERC’s required pre-tax yield and going-in and terminal cap rates for unleveraged apartment properties remained unchanged in third quarter. Reis does not expect vacancy to improve much in 2014, but effective rent should improve approximately 3.3 percent annually for this sector.
Hotel. Fundamentals for the hotel sector, which is generally viewed as slightly more risky than the other property sectors, have been steadily improving over the past year. According to Smith Travel Research, occupancy increased to 67.8 percent in 3Q13, a YOY increase of 5.8 percent. In addition, the average daily rate climbed to $115.47, an increase of 8.3 percent from the previous quarter, while revenue per available room rose 14.5 percent to $78.31. Unlike the other property sectors, transaction volume and pricing declined for the hotel sector in 3Q13 from the previous quarter, but the third-quarter volume of $5.7 billion and the average price of $136,473 per unit was 14.0 percent higher than year-ago volume and price, per RCA. In addition, investors are requiring a slightly higher risk premium for investing in hotel properties, and RERC’s required pre-tax yield rate increased 20 basis points to 10.0 percent in third quarter for unleveraged hotel properties. RERC’s required going-in cap rate remained unchanged at 8.0 percent, while the required terminal cap rate increased slightly to 8.7 percent. After minimal supply growth during the past couple years, hotel construction is expected to begin to increase, with occupancy, ADR, and RevPAR increasing at a similar pace in 2014.
Effects on Alpha
RERC expects appreciation on commercial real estate — and total returns by extension — to slow slightly in 2014 as we gain clarity in monetary policy and other issues. If the Federal Reserve tapers its policy of monthly bond purchases soon, money may be less available and become more expensive in 2014. In addition, appreciation is likely to decline as sales of class B or good-quality assets in second-tier markets become more common.
RERC forecasts aggregate National Council of Real Estate Investment Fiduciaries values as presented in the NCREIF Property Index to increase by approximately 2.75 percent throughout 2014. As of 3Q13, year-to-date values have increased by 3.9 percent and total return has increased by 8.3 percent. RERC’s projection is bracketed by upside and downside scenarios that reflect a projected value change in 2014, with the base case near 2.75 percent for appreciation. Add an income return of 6.0 percent and total returns in 2014 are expected to have a base case near 8.75 percent on an unleveraged basis for the year.
Although commercial real estate returns were mostly favorable in 2013, the risk for commercial real estate is inching up, as demonstrated in Table 1, where the 3Q13 return vs. risk rating for commercial real estate overall declined to 5.6 on a scale of 1 to 10, with 10 being high. The ratings in this table also show that investors anticipate slightly lower near-term returns in comparison to the amount of risk for the office and industrial sectors, and slightly better returns compared to the risk for the retail and apartment sectors.
Further, RERC’s value vs. price rating, also shown in Table 1, declined slightly for commercial real estate overall in third quarter, as well as the ratings for the office, industrial, and retail sectors, indicating that the value is declining slightly in relation to the price. As depicted, the value vs. price rating for the apartment sector has already declined to 4.8 on a scale of 1 to 10, with 10 being high, suggesting that the value for this sector is already generally less than the price of this property sector. Interestingly, the value vs. price rating for the hotel sector was slightly higher, reflecting slightly higher value in relation to the price.
Risk: It’s a Fact of Life
While many wonder whether the return on commercial real estate, particularly in challenged markets, will outweigh its risk, it is important to remember that there is an element of risk in every investment. However, broadly speaking, RERC believes that commercial real estate is still a good investment compared to the alternatives, and that returns are available on a risk-adjusted basis to astute investors.
The investment characteristics for real estate are more transparent than those for many other investments. Part of the value of the asset class is that it is a tangible asset vs. a paper asset. In addition, commercial real estate offers reasonable returns, and although the returns are generally not as high as recent stock market trends, they are not as volatile either. Finally, commercial real estate returns are based on both appreciation and dividends, therefore providing a reliable source of income. And when all is said and done, that may be as good a way to pursue alpha as any.
Kenneth P. Riggs Jr., CCIM, CRE, MAI, is president of Real Estate Research Corp. (www.rerc.com) and publisher of the quarterly RERC Real Estate Report. For more information or for a special CCIM discount to the report, contact RERC at email@example.com.
2014 Opportunity Markets
Although commercial real estate has generally recovered in many of the major coastal markets and prices have returned to pre-recession levels — and some reports show prices surpassing those levels in some cities — there are still good opportunities to purchase quality properties throughout the U.S.
Seeking Alpha in 2014
• Both debt and equity will likely be more expensive in 2014, although liquidity should be available for good investments. If you haven’t already done so, lock-in low interest rates soon.
• The coastal markets are likely to be too expensive for the majority of commercial real estate investors, but there should be good opportunities for pursue solid risk-adjusted returns in the secondary and tertiary markets.
• Niche properties such as storage, student housing, and medical-related facilities offer diversity from core property selections.
• Property fundamentals are not expected to increase broadly in 2014, as economic growth is expected to remain sluggish.
• Total returns are likely to decline slightly in 2014, as the appreciation component of commercial real estate investment is likely to see downward pressure compared to 2013.
• Generally speaking, look for industrial properties to continue to perform well, along with neighborhood/community retail properties.