Commercial Real Estate: CRE’s stability makes it more appealing than other investments

In 3Q 2018, commercial real estate (CRE) total returns declined, but investors are con¬tent with the enduring stability of its income component, because of the wildly fluctuating returns for other asset classes.

This is one of the many conclusions presented in the recently released 3Q 2018 Situs RERC Real Estate Report, “Under Pressure.”

One of the longest economic expansions in US history is continuing, with nearly full employment and solid GDP growth. As the cycle progresses into its ninth year amid rising interest rates, CRE returns are expected to continue regressing gradually from their previous peaks. With capital appreciation generally declining over the forecast period, and cash flow hitting a steady but slow level of growth, CRE will need to rely on income to drive total returns moving forward.

The Situs RERC Total Return Forecast is based on proprietary modeling of Situs RERC data and data from the NCREIF Property Index (NPI-ODCE) and is for leveraged, institutional-grade properties. Total returns are derived from an income component and a capital appreciation/depreciation component. Although Situs RERC provides individual forecasts for each of these components, it is important to note that Situs RERC’s forecast for NPI-ODCE returns assumes interdependency among these (and other) metrics. Therefore, any changes in one metric would affect the other forecasts as well.

Although NPI-ODCE returns have been strong over recent years, it is important to note that annual returns have been decreasing since 2015. After a steeper decline from 2015 to 2016, the NPI-ODCE total return fell from 7.5% in 2016 to 6.9% in 2017. Nonetheless, Situs RERC’s base case (i.e., most probable) scenario predicts the NPI-ODCE annual total return will increase in 2018, reaching approximately 7.5% before declining again to just over 6.0% in 2019. Income returns will continue to drive the majority of total returns.

INCOME COMPONENTS OF TOTAL RETURNS

Per NCREIF, the free cash flow yield (FCFY) is the quarterly net operating income (NOI) minus ordinary or routine capital expenses, divided by the beginning market value in the quarter. It focuses on quarterly net cash flow from operations, which accounts for ordinary or routine capital expenditures. This measure represents additional income beyond rent that investors can expect to receive from investing in the properties at a particular time and is comparable to stock dividend yield after capital expenditures have been paid. Our base case scenario calls for FCFY to increase through the end of 2018, reaching about 3.0%, but then stabilizing around 2.5% by 2020.

NCREIF implied cap rates can be interpreted as the current quarter NOI divided by the current quarter-ending market value. This result is then multiplied by 4 to get an annual rate. After falling to a historic low of 4.3% in 4Q 2017, it increased in the first half of 2018. Situs RERC’s base case scenario predicts the NCREIF implied cap rate will decline again, sliding to a new historic low of just under 4.5% by the end of 2018.

THE CAPITAL COMPONENT OF TOTAL RETURNS

CRE value can be described in terms of a price change, which combines capital expenditures and capital returns, or capital appreciation only. Situs RERC’s capital appreciation forecast provides an alternative way to examine prices, because a significant portion of the run-up in CRE prices is due to capital improvement projects (including leasing activity).

Capital returns have been declining since 2015. While Situs RERC’s base case scenario has capital appreciation increasing from 2.3% in 2017 to approximately 3.0% by the end of 2018, we expect capital appreciation to resume its downward trend over the forecast, falling to about 1.0% by 2020.

Full results are available in the 3Q 2018 Situs RERC Real Estate Report, “Under Pressure.”

This is the nation’s longest-running real estate research report offering investment criteria and investor insights on all the major markets and property types.

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