In 4Q 2018, commercial real estate (CRE) total returns continued to decline, but investors remain satisfied with the stability of their income component given the volatility of other asset classes.
This is one of the many conclusions presented in the most recent Situs RERC Real Estate Report, “Staying on Track.”
Over the next few years, 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 Situs RERC’s proprietary model based on data from Situs RERC and 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 steep decline from 2015 to 2016, declines for the NPI-ODCE total return have been less severe. Situs RERC’s base case scenario predicts the NPI-ODCE annual total return will decline from 6.82% in 2018 to approximately 5.5% by 2021. Income returns will continue to drive the majority of total returns.
THE 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 decrease to about 2.4% in 2019, but increase to near 2.5% in 2020 and 2.6% in 2021.
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. In 4Q 2018, the national NCREIF implied cap rate reached a historical low of 4.21%. Situs RERC’s base case scenario predicts the NCREIF implied cap rate will increase from approximately 4.3% in 2019 to near 4.5% in 2021.
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. Situs RERC forecasts that appreciation will continue to decline in the next few years from about 2.4% in 2018 to about 1.0% in 2021.
Full results are available in the 4Q 2018 Situs RERC Real Estate Report, “Staying on Track.”
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