Commercial Real Estate: A new approach for the post-crisis era

The following article, written by Ken Riggs, CFA, CRE, MAI, FRICS, CCIM, President of Situs RERC, was recently published in Commercial Property Executive.

Time continues to march on, and we are now a decade past the GFC and in the midst of the longest recorded economic expansion in U.S. history. Given the severity of the GFC and all the brakes that we hit to avoid Armageddon, this historic occasion should not throw us too off-balance. But this expansion has been full of surprises. GDP growth is strong and the economy continues to add jobs; the unemployment rate is at a 50-year low. The stock market, though volatile, is near historic highs. Oddly, inflation has barely budged. CPI hasn’t pushed past 3 percent since 2011 and averaged just 1.7 percent over the past recovery — a far cry from the 14.5 percent in 1980.

The low short-term interest rates set by the Fed over the past decade have also been historic. When the recession officially began in December of 2007, the fed funds rate was at 4.25 percent. For seven years, the Fed kept the rate at effectively zero. Even with several short-term increases over the past year, the rate remains historically low.

Yet long-term interest rates have not been responding in kind. As recently as the first quarter of 2019, the 10-year Treasury was 2.7 percent (quarterly average). It fell to 2.4 percent by the end of May ― the lowest monthly average since December 2017. The 10-year rate didn’t break 2.15 percent in June of this year.

Interest rates in other advanced economies are also extremely low ― some in mind-bogglingly negative territory. When you throw in domestic and global geopolitical uncertainty, it’s easy to see why investors aren’t brimming with confidence.

In light of these developments and how far we are into this recovery from the GFC, CRE investors are taking defensive positions, leaving behind the era of aggressive underwriting tactics that we witnessed just prior to the last recession. As we know, one of the main benefits of investing in CRE is that it is a tangible asset with a solid income component. This allows investors to pick the property types that have less volatile income streams and hold them for the long term. It also allows investors to diversify their investment portfolios to hopefully protect their downside. With apparent and reasonable cash flow, likely aided by the psychological scars of the GFC, an asset price bubble is being fought off, but that does not suggest we have ended cycles or a market correction is not coming along. We just don’t know when the correction will occur and how large it will be.

The best defensive opportunities lie in the industrial and apartment sectors. Industrial still has pricing power amid robust investor demand. The sector has the most favorable near-term fundamentals of all the property types; vacancy rates are expected to remain near record lows for warehouses and data centers. After all, the e-commerce trend is not going anywhere; as it continues to carve out a larger share of retailing, warehouse demand is expected to remain strong. Although apartments have been bid up and have seen a long run of price appreciation, the property type remains a relatively stable investment return.

But investors need to watch out for a changing regulatory landscape and more populist policies, which will affect CRE as a whole. These changes will make things more complicated ― and costly ― for investors in CRE as they try to navigate their portfolios during a time of lower economic growth and higher uncertainty. Setting realistic expectations about returns is key. CRE yields may currently be low but the 10-year Treasury yield is lower, so CRE remains a lower risk than other investment alternatives.

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