Why Investors Are Bullish on Commercial Real Estate
In commercial real estate, optimism is back. Property performance through Q3 2021 reflects sizeable gains for property investors, while interest rates and inflation are of limited concern for the asset class.
Investment returns on institutional quality real estate hit a 15-year high in the third quarter of 2021, according to the National Council for Real Estate Investment Trustees (NCREIF). NCREIF tracks the performance of commercial real estate and institutional quality funds using data provided by its investment management members.
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The total return of the NCREIF Property Index (NPI) for the third quarter of 2021 was 5.2%, composed of a return on income of 1% and a return on capital (or capital growth) of 4.2%. The last time the NPI’s total quarterly return was above 5% was in the fourth quarter of 2005. In context, the 20 year average total quarterly return is 2%.
Commercial real estate performance in the third quarter of 2021 was breathtaking. But it is also impressive in view of the very short and flat depreciation cycle in 2020. The depreciation, as measured by the return on investment, lasted only two quarters (Q1 and Q2 2020) and resulted in a cumulative depreciation of only 2.7%. As a result, commercial property scores in the NPI are already 5% above their pre-pandemic peak.
Rents were under pressure at the beginning of the COVID-19 pandemic, when tenants returned space to the market for sublet or delayed new rentals. The economy is booming again in 2021. On an annual basis, economic growth is also at its highest level in 15 years. In addition, 18.5 million of the 22.4 million jobs lost during the pandemic had been regained by November 2021.
What about the interest rates?
Interest rates are likely to rise in 2022 as the Federal Reserve completes its reduction in bond purchases. It is possible that the federal funds rate will increase in 2022, but that would be a data-driven decision based on continued strong economic growth.
More growth is good for real estate, but higher interest rates can affect values through capitalization rates (cap). Cap rates measure property income as a proportion of market value. For NPI real estate, the cap rates of the current valuations between the second quarter of 2020 and the third quarter of 2021 are a historically low average of 4%.
Although the cap rate is low, the cap rate spread – the difference between two cap rates and 10-year US Treasuries – is larger than its long-term average. The 20-year historical average cap rate spread is 250 basis points (bps), compared to 266 bps in the third quarter of 2021 and an average year-end average of 275 bps. In other words, the cap rate spreads will generally increase. A wider spread indicates that commercial real estate can offer better returns and allows the spread to narrow in response to higher interest rates rather than the caps increasing.
What about inflation?
Inflation is the reason for expected interest rate hikes, but also a driver for capital flows in real estate. Commercial properties are seen as protection against inflation, as rents paid to owners tend to rise with the general price level, which supports returns in periods of inflation. For non-income assets, inflation can affect performance.
Economic growth to date has driven this commercial property performance, and the recovery is not even over. At this point in the real estate cycle, there are opportunities to benefit from rising rents, rising demand for space or – depending on the property – from both.