In the Next Downturn, Public Markets Will Be CRE Investors’ Best Bet
- Apr 24, 2019
We are frequently asked where the real estate investment opportunities will be during the next down cycle. Our advice is to watch for opportunities in public markets, rather than in the private markets, which defined the down cycles in the early 1990s and 2000s. A prevalence of public-market opportunities characterized the 2008-2010 downturn, and we believe this will again be the case.
Our reasoning is that greed swings more rapidly to fear (and back again) in the public markets. In addition, private-equity dry powder—totaling more than $325 billion, as Prequin reported in February 2019—will create fairly competitive bidding for private assets, even in the face of fear. So we suggest that those hoping to prosper from deeply discounted pricing during the next down cycle should start educating themselves on REITs today so they are ready to jump in when the time is right.
We expect commercial real estate to perform well in 2019-2020 even as interest rates increase, due to continued capital flows and solid NOI growth. Contrary to mythology, real estate equity returns have historically been better during periods of rising interest rates, partly because owners had locked in low long-term fixed-rate debt, while enjoying increased incomes from improved occupancy and higher rents.
For several years, we have said that cap rates are determined by the flow of funds, rather than interest rates. This has proven true over the past three years, with interest rates rising and falling with no identifiable impact on cap rates. A simple way to see why this is the case is to realize that development will expand commercial real estate stock about 6 percent over the next three years. If this larger inventory competes for the same amount of capital as deployed today, values will fall; that is, cap rates will rise. This will be true, irrespective of interest rates. In contrast, if 25 percent more capital is chasing just 6 percent more real estate, values will rise and cap rates will fall—again, irrespective of interest rates.
As we look forward, with the large excess reserves of money-center banks and real estate private-equity dry powder totaling more than $325 billion globally, we expect cap rates to hold, even as interest rates rise. Of that $325 billion of committed but unspent equity capital, some 15 to 20 percent is targeted for the U.S. As the main providers of commercial real estate debt, banks continue expanding their mortgage book by 4 to 5 percent year-over-year.
In addition, CMBS issuance is a net positive source of real estate capital, while life companies and government-sponsored entities continue to be active lenders, as well. All told, despite negative flows to real estate mutual funds, we expect that both the flow of funds to real estate and cap rates will remain solid in 2019.
Dr. Peter Linneman is a principal and founder of Linneman Associates and Professor Emeritus at the Wharton School of Business, University of Pennsylvania. Follow Dr. Linneman on Twitter: @P_Linneman