Economist’s View: The Coming Golden Age of Asset Management

Commercial real estate occupies an important place in the investment universe. It offers diversification benefits, but more importantly, it produces income like a bond, with the ability to also generate at least modest appreciation return. Therefore, CRE investors frequently expect the majority of the return to come from income and the minority from appreciation. Yet while once true, the return composition no longer follows quite that pattern, even for core investment strategies.

Over the last four business cycles, an interesting pattern emerged. Gradually, on an absolute and relative basis, income returns have decreased while appreciation returns have generally increased. This occurred across data sets and data points, but NCREIF’s NPI index proves most instructive. The NPI represents returns from stabilized, high-quality properties on an unlevered basis. Consequently, it provides returns for a group of properties that should generate their returns largely from income. Other CRE strategies, such as value-add, take a more risk-seeking approach and aim to generate more of their returns from appreciation.

The NPI data shows that over the last (roughly) 40 years income returns have fallen by half—from about 2 percent to about 1 percent quarterly. Meanwhile, though more volatile, appreciation returns have reached higher peaks with each subsequent business cycle. On a rolling four-quarter basis, appreciation returns during the expansions of the 1980s and 1990s peaked at about 2 percent and never exceeded the rolling four-quarter income return. More recently, rolling four-quarter appreciation returns have increased, exceeding 3 percent during the 2000s, nearing 2.5 percent during the 2010s, and hitting 4 percent in the post-pandemic period. Moreover, during these expansions, appreciation returns have exceeded income returns—sometimes for prolonged periods.

But why have appreciation returns spiked over time, even for core CRE? Because of the structural decline in interest rates between the early 1980s and the pandemic. Structurally declining interest rates reduce discount rates and cap rates over the long term. And the impact of declining rates on appreciation is nonlinear and becomes more pronounced as rates decline. For example, a change of 50 basis points has a greater impact on discount rates and cap rates at 5 percent than at 10 percent. But the period of structurally declining interest rates appears to be over. Instead, rates will fluctuate over time within a range as opposed to the massive drop from double digits in the early 1980s to zero percent in the GFC and pandemic.

The upshot is that many investors have confused their own genius with structurally declining interest rates over the last few decades. With interest rates now rangebound, outsize appreciation returns will be harder to generate, at least on a prolonged basis. And when interest rates increase, it will be easier to give back appreciation returns based largely on temporary declines in interest rates. Income returns will likely become a bigger component of total returns once again. And that could herald a “Golden Age of Asset Management,” as asset managers responsible for the performance of individual properties play a more prominent role in generating income and total returns. This asset management process takes a holistic view around maximizing revenue and minimizing expenses. It leverages unique skillsets such as the use of IT and proptech, managing construction and development, marketing of properties and suites, and the use of leverage to navigate the complex capital markets of today’s CRE world. It importantly employs an empathetic lens, working with tenants and their employees to arrive at solutions together, not seeing tenants as the opponent.

Other investment personnel will remain important. But after decades when declining interest rates boosted appreciation returns and papered over a lot of mistakes that investors made, organizations with highly skilled asset management teams will set themselves apart from those that simply rode the wave of declining rates. Income returns should become relatively more important than they have been in decades, and skilled asset management teams will play a large role in generating them.

Ryan Severino is the chief economist & head of research at BGO, where he is responsible for global and regional economic research, analysis and forecasting, as well as property market research, insights and forecasting. Additionally, he is an adjunct professor at Columbia University and New York University. Severino holds a master’s degree from Columbia University and a bachelor’s degree from Georgetown University, and is a CFA charterholder.

Read the March 2024 issue of CPE.