Focus on Investment Conditions: Commercial Real Estate Keeps Its Healthy Pace

Article excerpt

ALTHOUGH MANY SIT ON THE EDGE OF THEIR SEAT as commercial real estate continues to provide relatively strong and solid returns, commercial real estate as an investment class is being viewed in a new light and is considered to be an increasingly important asset in the financial world.

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Buoyed by low interest rates during the last few years, we watched as record-level home sales and new construction, along with loan refinancing, helped pull the U.S. out of a recession. GDP grew, employment grew, and as a result, in 2004, soaring home values and rising stock prices drove the wealth of American households up by 9% to a record $49 trillion, states the Federal Reserve.

With consumers spending even more and businesses growing and finally beginning to occupy more space, record levels of capital flowed to the commercial mortgage markets in 2004. In fact, real estate was among the biggest mutual fund winners in 2004, earning 32% returns on average for the year. This was the fifth consecutive year that public real estate investment trusts (REITs) outperformed the major stock market indices, reported Lipper.

Although private real estate returns are decreasing, real estate returns overall remain less volatile than stocks, and as shown in Table 1, are outperforming those for other investment classes. As such, demand for real estate remains high, with pension funds, endowments, foundations, and individual investors boosting their investment in commercial real estate.

COMMERCIAL MARKETS REFLECT BUSINESS AND CONSUMER TRENDS

The Federal Reserve indicates that it will continue to raise the federal funds rate and to monitor the rate of inflation. The fear is that an increase in interest rates and inflation, along with high fuel rates and a slowdown in consumer confidence, will slow consumer and business spending, and that the real estate recovery--now off to a solid start-will stall. However, real estate's propensity to lag the economy is also one of its most stabilizing features. Since most commercial real estate properties do not move on a moment's notice, there is time for investors to study the fundamentals, evaluate return expectations, and make more informed investment decisions.

One of the most significant findings that Real Estate Research Corporation's (RERC's) second quarter 2005 research indicated was that required pre-tax yield rates and required going-in and terminal capitalization rates continue to decline for all the major property types except hotels. How much more investors will lower their expectations is unknown, but we believe this further decline suggests that the changes in the financial and commercial real estate arenas are increasingly more structural rather than cyclical, and a larger proportion of this downward shift is here for the long term.

WHAT ABOUT RETURNS ON INVESTMENT?

Office Sector -- As for the office sector, RERC's survey respondents indicate that investment conditions have improved quarter by quarter for both CBD and suburban office properties during the last year. Office jobs continue to increase, especially in the financial and services sectors, and little by little, vacancy rates are improving.

As shown in Table 2, NCREIF 1-year returns are averaging above 13% for CBD and suburban properties. However, due to several factors, including high capital expenditures and relatively higher vacancy rates, there is a great deal of uncertainty associated with office investments, which is reflected in the variation in return from this asset. As such, the risk-adjusted returns for the office sector reside in the bottom half of the spectrum. However, what made office properties so risky over the last several years may be investors' biggest ally in generating higher total returns today. Investors are advised to be wary of rising interest rates, as many of our survey respondents believe capitalization rates have bottomed-out, as demonstrated by RERC's relatively high required returns for suburban properties. …