The Progression of Commercial Property
Some investors worry that the usual metrics used to measure aggregate commercial real estate investment pricing are starting to look overheated, at least as they relate to “core” real estate properties. Metrics such as replacement costs, peak pricing, spreads (cap rates over corporate and government bonds) and replacement rents are at relatively high levels in many regions. Particularly in the main global “gateway” markets -- New York, London, Tokyo, etc. – most of those metrics are indicating that real property assets in those markets may be generously priced.
Other observers disagree. “We don’t think there’s a broad-based bubble in the in the real estate market today nor do we think there’s one coming in the next year or two,” recently said Chris Graham, a senior manager at Starwood Capital Group. “While these [major city] assets are fully priced, in my view, we are not in a bubble as that would require an extensive expansion in debt,” said Paul Vosper, co-head of the Morgan Stanley Alternative Investment Partners Real Estate Fund.
The more bearish commercial real estate investors worry about comparisons to the years just prior to the Great Recession. Then, interest rates were rising but spreads were below their historical averages in those key markets, even going negative in some instances. In addition, pricing hit all-time highs and replacement cost and replacement rents were replaced by the utilization of over-optimistic forward-looking pro forma figures.
The current environment is not as bad as that, say many analysts. “While the debt markets are expanding, there is still discipline in the credit underwriting of that debt,” said Mr. Vosper. Mike Kelly, director of U.S. real estate commingled Funds at J.P. Morgan Asset Management, agreed there was no bubble. “It's certainly a competitive market,” he said, but noted that real estate remains attractive compared to other asset classes. "When we look at the spread between the 10-year Treasury, which today is around 2 percent, and a 6 percent (investor rate of returns) on a very good quality piece of real estate, we think that spread is attractive," Kelly said.
Other observers agree. A recent Economist article pointed out that in both the cash and government-bond markets, yields are low or even negative, and that by comparison, yields of 5% on American property or even 4% on office blocks in central London look attractive.
Commercial real estate can be vulnerable to (among other things) three circumstances: a rise in interest rates, a downturn in the economy that adversely affects demand for property, and a burst of speculative building that leads to oversupply.
On the first point, other than in America and Britain, central banks are still cutting rates in much of the world. There don’t seem to be any overriding macroeconomic factors pushing inflation higher, and so central banks are likely to remain cautious.
The world economy is not exactly booming, but forecasts predict GDP growth of more than 1% in the euro area and Japan and more than 3% in America.
And as for supply, globally there has yet to develop the kind of development spree that usually marks the peak of the property cycle. In America, new commercial real estate construction is at a fraction of normal levels.
Value-Add Properties in Secondary Markets – The Way to Go?
If core gateway assets seem pricey, investors might consider some alternatives:
Value-Add Properties. Significant opportunity can remain in for value-add strategies in the top performing markets. While supply has remained low, demand has been increasing. Existing buildings are continuing to age and are becoming functionally obsolete.
Secondary Markets. High-performing secondary and tertiary markets (e.g., Austin, Denver, and Nashville) may be attractive as the recent recovery has been geographically broad-based. A broad array of economic drivers are spread around the country.
Less Competition from Institutions. Secondary and tertiary markets also tend to be ignored by larger institutional investors. These regions are smaller and are often not closely monitored by pension funds, sovereign wealth funds and similar larger capital providers. This could potentially mean that greater returns might be available in such markets.
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