CRE Finds Clarity in the Long View

Ken Riggs. Photo courtesy of RERC LLC

The ongoing trade disputes, geopolitical conflicts and policy ambiguity are having a profound impact on the entire investment landscape. In order to rise above the uncertainty, investors need to think with a rational and careful approach, look through the day-to-day barrage of media headlines and use a long-term value investing approach to determine which investment is best among the alternatives.

Taking a long-term value approach and evaluating on a risk-adjusted basis, RERC’s grounded perspective is that CRE is the asset class that has done the best during the 10-years-and-counting economic expansion. CRE was an attractive alternative during the early years of the recovery because it offered a real, tangible asset class with a strong income component. As 10-year Treasurys have been generally between 1.5 percent and 3.0 percent over the past five years, a 5 percent-plus income return has been a major strength for the CRE market. When you include years of double-digit returns, it is easy to see why CRE is well positioned for the next recession, relative to the alternatives.

With investor uncertainty driving demand for relatively safe government bonds, we are seeing exceptionally low (and even once-unheard-of discussion of negative) bonds in the U.S. RERC sees the declining rates as a positive for CRE investment. Decreasing interest rates will result in a widening of the CRE yield spreads, and the expanding spreads might lead to increased risk-adjusted returns as the relative benefit of a risk-free benchmark begins to erode. CRE is capital intensive. Declining interest rates will reduce the cost to secure loans, making it easier to fund deals. Declining interest rates will also likely bolster CRE debt markets, which were expected to experience a cyclical downturn this year, as reported in Commercial Mortgage Alert. At a time when overall cap rate compression has stalled, a boost of capital may jump-start the mar­ket once again. The added juice is unlikely to create an asset bubble, however, because capital remains disciplined and rational.

Unlike the financial markets that have been at the whim of a tweet, the CRE market takes a long-term view. We don’t see huge swings in valuation based on the day’s events. Nonethe­less cyclical changes, such as overbuilding, and structural changes, such as the way the inter­net has transformed the way people work, play and live, are critical to consider when predicting where the CRE market will go—especially as we face the eventual economic downturn.

Not all property types are created equal, though.

The industrial market continues to shine with buyers paying high premiums. The sector’s fun­damentals remain best among property types due to limited supply and exceptional demand caused by the continued growth in e-commerce.

The apartment sector keeps forging ahead, as it has been throughout this long economic cycle, even as some markets face oversupply. Continued low unemployment and modest wage growth are cur­rently supporting strong fundamentals, while bar­riers to homeownership will continue to result in strong demand for apartments, especially in pricey gateway markets.

Low unemployment is also supporting fundamentals in the office sector, but structural changes due to demographic trends and technology are likely to reduce office demand in the future. RERC is also seeing increasing tenant improvements for both the suburban and CBD office sectors.

The retail sector is soft—at best—with rising vacancy putting pressure on net operating income. Mall and power center values have taken a hard hit and lifestyle center cap rates have begun to rise.

Ken Riggs, CFA, CRE, MAI, FRICS, CCIM, is president of RERC, a SitusAMC company.