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The Risk Factor

 
Commercial real estate offers stability to nervous investors.
 
Just a few short months ago the recovery seemed to be finally taking hold. Gross domestic product growth was increasing, job growth was strengthening, retail sales were starting to pick up, and the stock market — including real estate stocks — was gaining steam. Investors finally were recouping some of the wealth lost in the recession and thinking that prosperity was just around the corner.

This confidence was short-lived, however, as a confluence of events occurred: Japan’s earthquake, civil war and upheaval in the Middle East and northern Africa, Europe’s expanding sovereign debt crisis, and the downgrading of the U.S. debt outlook to negative, to name a few. Add to that increasing layoffs among federal, state, and local government workers, a still-deteriorating housing market, tornados and floods in the southern U.S., and higher prices for food and fuel, and uncertainty soon replaced investor confidence.

This economy is not about to tumble back into recession, but it does remain fragile. The recovery, which resembles a marathon more than a sprint, has a long way to go and may slow down or stumble a few more times before the finish line. The U.S. is working off a recession unlike any experienced in more than 70 years, and it will take time to move through this period that is riddled with unforeseen events.

Risk Aversion Continues

Such a long-term view is ideally suited to commercial real estate, which remains a relatively stable investment, given such uncertain times and the volatility of the financial markets. Considered much less risky than many other investments, commercial real estate is tangible and transparent: Investors actually can see the number of tenants and calculate the amount of rent they expect to receive each month. In addition, as the NCREIF Index and NAREIT Index returns indicate, commercial real estate has been holding its own as compared to other investment alternatives. (See Exhibit 1.)

The potential for such returns, along with less risk associated with this asset class in general, makes commercial real estate — on an institutional level or in the secondary or tertiary markets — particularly attractive to those who are risk averse. In comparison to other asset classes and given the continuing low-interest rate environment for 2011, members of the CCIM Institute, as reported in the RERC/CCIM Investment Trends Quarterly, continue to rate commercial real estate as a preferred investment alternative to stocks, bonds, or cash. (See Exhibit 2.)

Although record sale prices of high-quality properties have occurred in some of the nation’s top markets over the past few months, most commercial properties still garner little to no investor interest. Bifurcation remains evident in the sales volume and prices of trophy properties versus other properties.

Even among institutional properties in the nation’s top metropolitan areas, there is a wide differential of return on capital investment. (See Exhibit 3.) Out of the nation’s top 44 markets, the five metro markets with the highest post-recession capital return averaged a 13.4 percent return over the past five quarters, according to NCREIF. However, the remaining 39 metros yielded a return of only 4.8 percent, for an average of 5.7 percent for all metros. This flight to quality by investors caused demand to increase in the best markets; thus, values for the best institutional markets have increased at a much faster rate than in secondary markets.

Unfortunately, the lack of demand in most secondary markets, along with the increased supply of distressed or foreclosed properties, has reduced property values in those areas. However, the pressure on institutional properties should prompt investors to move out on the risk spectrum to smaller properties and smaller markets. The movement of both these extremes is necessary in the real estate recovery process, and this trend will continue throughout 2011.

It also is important to note that commercial real estate and the capital markets are inextricably interconnected. The risk associated with rising interest rates (it is just a matter of when and how much) is already built into the rates of return for commercial real estate, as shown in the spread between RERC’s going-in capitalization rates and 10-year Treasuries. (See Exhibit 4.) Further, this spread demonstrates that commercial real estate is providing the highest level of return over Treasuries from a 20-year historical perspective. It is problematic to forecast interest rates, but the attractive risk-adjusted returns are why capital is flowing into commercial real estate today, and why it will continue to do so.

With respect to property sector risk, apartment properties received the highest return versus risk rating during first quarter 2011, with a rating of 6.7 on a scale of 1 to 10, with 10 being high, followed by the industrial sector with a rating of 5.5, indicating that the return on these two property types was generally higher than the amount of risk involved. The office sector received a rating of 4.5, the lowest return versus risk rating among the major property sectors, with the retail and hotel sectors each receiving a rating of 4.8. (See Exhibit 5.)

Value Recovery Underway

CCIM members also are seeing a recovery in value for each of the major property types. The value versus price rating increased over the previous quarter for every property sector, indicating that CCIM members in general believe the value of property is higher than the price being paid. (See Exhibit 5.)

With a rating of 5.7 on a scale of 1 to 10 with 10 being high, the industrial sector received the highest value versus price rating, beating out the apartment sector for the first time in more than two years. The apartment sector rating increased slightly to 5.4, while the retail and hotel sector ratings each increased to 5.3. The office sector received the lowest value versus price rating, as well as the lowest return versus risk rating.

Overall, the outlook for the commercial real estate industry is for a continued but slow value recovery, as each asset class will have different levels of value recovery. RERC estimates that class A to B+ property values should increase by approximately 7.5 percent in 2011, which would be a cumulative value increase from the trough of approximately 15 percent. Class B to C+ properties and class A+ properties reflect a one-year value increase between 5 percent and 12 percent, respectively. Adding in an income return of 6.5 percent, total returns range from 11.5 percent to 18.5 percent on an unleveraged basis for 2011. (See Exhibit 6.)

Property Sectors: Follow the Fundamentals

Multifamily. Given the weak housing market and increasing demographics that favor the rental market, the apartment sector is the least risky of the major property types nationally and in most regional and metro areas. In addition, apartment fundamentals have been improving over the past year. Vacancy declined to 6.2 percent in 1Q11, according to Reis, and effective rent increased by 0.5 percent, with rents expected to continue to increase during the rest of 2011.

However, there is pricing pressure even for this tried-and-true property sector. According to RERC’s analysis, apartment sector volume increased by 17 percent during 1Q11 on a 12-month trailing basis for transactions of less than $2 million, although the average size-weighted price declined to approximately $36,550 per unit, which was about 9 percent lower than the previous quarter. The weighted-average cap rate for all transactions remained unchanged at 6.1 percent.

Industrial. Known as the “steady Eddie” of commercial real estate, industrial sector fundamentals also are improving. The availability rate fell to 15.9 percent during 1Q11, and asking rent grew 3.2 percent on an annual basis, according to Grubb & Ellis. Further, net absorption — primarily in the warehouse sector — is expected to rise to approximately 60 million sf in 2011 and could double in 2012. Although RERC’s 12-month trailing analysis indicates that the volume of transactions less than $2 million increased by more than 12 percent for this property type in 1Q11, the size-weighted average price of industrial space declined to $40 per square foot, approximately 9 percent less than the previous quarter. However, the weighted-average cap rate for all transactions declined by 10 basis points to 7.6 percent.

Retail. Although the retail sector carries the inherent risk of a weakened consumer as well as a general oversupply of product, the vacancy rate has remained unchanged at 10.9 percent for several quarters, according to Reis, and absorption is starting to improve. Neighborhood/community retail centers are faring better than regional malls, but asking and effective rents declined for both retail sectors by 0.1 percent. RERC’s 12-month trailing analysis shows that the volume of transactions less than $2 million increased by more than 16 percent in 1Q11. A relatively high number of distressed and foreclosed sales comprised the transactions for the retail sector (along with the office and hotel sectors); however, the size-weighted average price of retail space declined by 9 percent to around $68 psf. Even so, the weighted-average cap rate declined 50 basis points during first quarter, dropping to 7.7 percent.

Hospitality. Last year was good to the hotel sector, and the early forecast was for further strengthening fundamentals in 2011. However, subdued consumer spending and increasing gas prices have weakened the hotel sector, increasing hospitality’s investment risk somewhat. Even so, occupancy increased 12.2 percent to 60.8 percent in 1Q11, according to Smith Travel Research, and the average daily rate increased 5.3 percent to $100.18, while revenue per available room increased 18.1 percent to $60.91. In addition, volume for hotel transactions less than $2 million increased approximately 30 percent in first quarter, according to RERC’s 12-month trailing analysis, although the average price per unit declined 18 percent to about $17,950. The weighted-average cap rate remained steady at 7.1 percent for hotel properties.

Office. Given the lack of office-using employment growth and the increasing ability to work from home, the office sector, especially in most secondary markets, is generally the riskiest investment property. However, there are some positive fundamentals. Office vacancy declined to 17.5 percent in 1Q11, which was the first decline since the recession began, according to Reis. Absorption was positive and asking and effective rents increased for the second consecutive quarter. RERC’s 12-month trailing analysis indicates that the volume of transactions $2 million or less increased by nearly 5 percent in first quarter, but the size-weighted average price psf of office space declined by about 5 percent to $76 psf. However, the weighted-average cap rate for the office sector increased by 10 basis points to 6.8 percent, the only property type where the cap rate increased during first quarter.

Top Investment Markets

The market is recovering by fits and starts. On a regional basis, the size-weighted average price psf of 12-month trailing transactions less than $2 million for all the major property sectors in the West region were significantly higher than the national average during 1Q11, while the price psf of Midwestern transactions less than $2 million were significantly lower than the national average.

On the other hand, RERC’s analysis shows that the average transaction prices for the South and East regions were mixed. The 12-month trailing size-weighted average price of industrial, retail, apartment, and hotel transactions of less than $2 million in the South were lower than the national average, while the price of office space was about the same as the national average. In the East, the 12-month trailing size-weighted average price for transactions of less than $2 million were lower than the national average in the office, industrial, and hotel sectors, while prices in the retail and apartment sectors were higher than the national average.

As investors move out on the risk spectrum and the resolution of distressed properties continues, the number of transactions will continue to increase in the secondary and tertiary markets. Already there is improvement in some of the major markets such as Washington, D.C., San Francisco, and Houston, and RERC’s analysis indicates that commercial real estate returns are poised for improvement in such markets as Oklahoma City, Denver, Pittsburgh, Baltimore, and Austin, Texas.  

Investors are incorporating a variety of creative strategies to avoid additional risk and to make their investments work. For investors who wish to avoid the 100-or-more-point gyrations of the stock market or the paltry returns of cash or bonds, commercial real estate and the measured risk available with this asset class could offer a reasonable return — if the terms of the investment are right.

Kenneth P. Riggs Jr., CCIM, CRE, MAI, is president and chief executive officer of the Real Estate Research Corp. and chief economist of the CCIM Institute. Contact him at riggs@rerc.com.

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