Is CRE On the Rise?

Will rising long-term interest rates spoil the environment of progressive CRE growth?
Kenneth Riggs

RERC, L.L.C. forecasts the commercial real estate industry will continue to increase in value and pricing during the year ahead, according to its annual report, Expectations & Market Realities in Real Estate 2015—Scaling New Heights.

“As noted in the report, the price of high-quality CRE has been increasing to new highs in some of the coastal markets and has even been expanding now in some secondary and tertiary markets,” Ken Riggs, RERC’s president, told Commercial Property Executive. “We believe that the drivers are there for CRE prices and values to climb even higher (scale new heights) this year. The big question is will rising long-term interest rates spoil this environment, which all depends on the strength of the economy and demand dynamics for CRE.”

According to the report, as investors look ahead to the rest of 2015, the chief thing they are watching is whether commercial real estate prices can be supported down the road with the underlying valuations. The difference between price and value needs to be taken into account by investors.

“The demand for CRE remains strong, and given the risks to the world’s economies, the volatility in the financial markets, and its place in the investment cycle, interest in this hard asset class as a ‘safe harbor’ investment is expected to increase,” Riggs said. “Plus, CRE fundamentals—vacancy rates, rents, etc.—have been improving, so as we stated in our forecast report, returns on CRE are generally quite reasonable in this low interest-rate environment.”

Riggs added that even if the Fed begins raising short-term interest rates later this year (as hinted this past week in their remarks to Congress), long-term interest rates will still be low on a relative basis for some time to come, citing safety, rational returns and a continued low-interest rate environment adding up for more price and value increases ahead.

The report shows that regional economic conditions, property types, and other factors play a role in CRE prices in specific locales, but in general, high population growth areas will continue to do well, along with higher quality properties in areas with strong CRE fundamentals.

So, while it appears likely that returns on top-quality properties in the major coastal markets like New York, Boston, San Francisco, Los Angeles, etc. may be reaching their peak and have little room to grow, risk-adjusted returns are increasing for high quality properties in secondary and tertiary markets like Houston, Orlando, Denver, San Jose, Riverside, Salt Lake City, Nashville, and Portland. In fact, on a risk-adjusted basis, some secondary and tertiary markets can offer even better returns than those associated with the primary markets.

“We have all heard the reports during the past year or two with some investors snatching up high quality properties in the top markets with almost total disregard for the price. Major costal core assets have been bid up to record prices with continued capital pressure,” Riggs concluded. “Investors continue to require reasonable returns on a long-term basis, but the risk that prices for top quality properties in the major markets may be outpacing values is increasing. Since CRE still provides reasonable returns, investors are looking to slightly smaller markets and alternate property types for good long-term risk-adjusted returns.”

The report echoes what many in the industry have been saying—the future of CRE looks very bright.