Why investors are bullish on commercial real estate
Optimism is back for commercial real estate. Real estate performance through the third quarter of 2021 reflects sizable gains for real estate investors, while interest rates and inflation are of limited concern for the asset class.
Investment returns for institutional grade properties peaked in 15 years in the third quarter of 2021, according to the National Council of Real Estate Investment Trustees (NCREIF). NCREIF monitors institutional grade commercial properties and fund performance, using data provided by its investment management members.
The total return of the NCREIF Real Estate Index (NPI) for the third quarter of 2021 was 5.2%, comprising an income return of 1% and a return on capital (or appreciation) of 4.2%. The last time the IPN’s quarterly total return was above 5% was in the fourth quarter of 2005. For context, the 20-year average quarterly total return is 2%.
The performance of commercial real estate in the third quarter of 2021 was breathtaking. But it’s also impressive given the very short, shallow amortization cycle in 2020. The amortization, as measured by return on capital, only lasted two quarters (Q1 and Q2 2020) and resulted in a cumulative depreciation of only 2.7%. As a result, commercial property values ââin the NPI are already 5% above their pre-pandemic peak.
Rents were under pressure at the start of the COVID-19 pandemic when tenants relocated spaces to the market for subletting or delaying new leases. In 2021, the economy is picking up again. Economic growth is also advancing at its highest annualized rate in 15 years. In addition, as of November 2021, 18.5 million jobs had been recovered out of the 22.4 million lost during the pandemic.
What about interest rates?
In 2022, interest rates are likely to rise slightly as the Federal Reserve completes the gradual reduction in asset purchases. It is possible that the federal funds rate will be raised in 2022, but that would be a data-driven decision based on continued strong growth in the economy.
More growth is good for real estate, but higher interest rates can impact values ââthrough cap rates. Cap rates measure property income as a share of market value. For NPI properties, cap rates on current valuations have averaged an all-time low of 4% from Q2 2020 to Q3 2021.
Although the cap rate is low, the cap rate spread – the difference between two cap rates and 10-year U.S. Treasury yields – is wider than its long-term average. The historical 20-year average capitalization rate differential is 250 basis points (bps), compared to 266 bps in the third quarter of 2021 and an average of 275 bps over last year. In other words, capitalization rate differentials are usually on the rise. A wider spread indicates that commercial real estate may offer better returns and allows the spread to narrow, as opposed to an increase in cap rates, in response to higher interest rates.
What about inflation?
Inflation is the reason interest rates are expected to rise, but it is also a driver of capital flows to real estate. Commercial real estate is considered a hedge against inflation because rents paid to landlords tend to rise with general price levels, supporting yields during times of inflation. For non-income earning assets, inflation can dampen performance.
So far, economic growth has boosted this performance in commercial real estate, and the recovery is not even over yet. At this point in the real estate cycle, there are opportunities to capitalize on rising rents, growing demand for space, or depending on the specific property, both.