A Risk-On State of Mind

By Ken Riggs, President & CEO, RERC: What’s a mind to think? Despite the 1 percent contraction in economic growth in the first quarter of 2014, which the markets have generally sloughed off, the net worth of U.S. citizens has never been higher.

Kenneth Riggs

What’s a mind to think? Despite the 1.0-percent contraction in economic growth in first quarter 2014, which the markets have generally sloughed off, the net worth of U.S. citizens has never been higher. According to the Federal Reserve, the value of homes, stocks, and other assets rose to $81.8 trillion, an increase of about $1.5 trillion or 2 percent, in first quarter. While approximately half of this increase is due to the rise in home values, the value of stocks and mutual funds also increased substantially.

In addition, consumers have deleveraged significantly since the beginning of the Great Recession. The Federal Reserve noted that total U.S. household debt was down to about 108 percent of disposable income in first quarter from a peak of about 135 percent in 2007. While this is good news for consumers, it is especially encouraging for businesses if consumers increase their spending levels. As a result, according to the National Federation of Independent Business, the small-business optimism index increased to 96.6 in May 2014, the highest rate since September 2007.

This optimism is no surprise to investors who have been relying on the Federal Reserve to maintain accommodative monetary policy, even as tapering continues, and who have been taking note of the M&A activity while cheering on the DJIA as it inches toward the 17,000-point mark. Most investors with this risk-on outlook seem to care little about whether stock values are inflated or not, as long as they can benefit from the bubble and don’t get caught holding the bag.

On the other hand, many commercial real estate investors are worried about commercial real estate that is priced for perfection and that a bubble could be brewing in the market. According to Real Estate Research Corporation’s (RERC’s) institutional investment survey respondents, there is definitely “too much money-chasing select investment opportunities” in commercial real estate. As shown in the accompanying graph, the gap between the availability (amount) of capital and the discipline (underwriting criteria) of capital further widened in first quarter 2014, as the availability rating increased to 8.2 on a scale of 1 to 10, with 10 being high, and the discipline rating dropped to 6.2.

RIGGS1

 

There are also indications that the price for core assets is at its peak in select markets. This, along with increasing availability of capital, makes it an ideal time to sell investment properties. As shown, this is the first time since early 2007 that the conditions for selling commercial real estate have been this strong.

Although these ratings indicate that we are entering a period of increased risk for lower returns for commercial real estate, RERC’s investment survey respondents believe that the return compared to the risk of commercial real estate overall has consistently improved since the end of the Great Recession. This is demonstrated by RERC’s return vs. risk ratings which gradually increased to 5.9 on a scale of 1 to 10, with 10 being high, in first quarter, compared to a rating of 4.1 in first quarter 2009.

RIGGS2

In addition, the return versus risk ratings for the office, industrial, and hotel sectors have consistently improved since the Great Recession ended in 2009. For the past two quarters, the return vs. risk rating for the industrial-property sector was the highest rating among all the property types. However, the big story when looking at these values over the past 5 years is the huge leap in the return vs. risk rating for the hotel sector. In first quarter 2009, the return vs. risk rating for the hotel sector was 2.8 and by first quarter 2014, the return vs. risk rating had increased to 6.1. With ratings above 5.0 for all sectors, investors believe that the return on commercial real estate still outweighs the risk.

RERC believes so too. However, we remember feeling that way in early 2007 too, and as such, remind investors to:

  • Do your due diligence. Some of the investment trends we are seeing now are similar to what we saw before the credit crisis in early 2007; the key difference between then and now is that today interest rates remain very low. However, if interest rates increase, investors could see an immediate loss in value vis-à-vis increased capitalization rates.
  • Expect fundamentals—particularly vacancy rates and rental rates–to continue to improve, albeit slowly. Except for the apartment sector, there has been relatively little new construction in most regions, and returns are expected to increase slightly—the question is, will any possible increase in returns be enough if interest rates increase?
  • Lock in long-term fixed interest rates soon, if you have not already done so. We have already seen hints of inflation, and once the Federal Reserve begins to raise the federal funds rate, the investment environment could change more quickly than expected.

There is always risk, and the investment climate always has uncertainty. However, the commercial real estate market is rational, returns are reasonable, and this asset class is still one of the better investments as a safe haven for nervous investors, at least for the next year.