The Sweet Spot?

By Bob Bach, Senior Vice President & Chief Economist, Grubb & Ellis Co. Despite the turmoil in Europe and the economic deceleration in the United States, commercial real estate is holding up well compared to other asset classes.

Despite the turmoil in Europe and the economic deceleration in the United States, commercial real estate is holding up well compared to other asset classes. Commercial property transaction volume rose by 31 percent through the first four months of 2012 compared to the same period in 2011, according to Real Capital Analytics Inc.
Investors are attracted by ultra-low mortgage rates, gradually improving leasing market fundamentals and solid returns, particularly for institutional-grade property. Investment returns have been outpacing returns on stocks and bonds over the past one- and 10-year periods. The National Council of Real Estate Investment Fiduciaries (NCREIF) reports that its National Property Index (NPI), which is based on transaction and appraised values of institutional-grade properties tracked in its database, returned 13.4 percent over the past four quarters and 8.2 percent annualized over the past 10 years, handily beating the S&P 500, the Barclays Capital U.S. Government Bond Index and 90-day Treasury bills (considered a risk-free benchmark). The NPI earned a split decision with the FTSE NAREIT All-Equity REIT Index, beating returns on publicly traded REITs over the past four quarters but trailing over the past 10 years. The NPI returns are unleveraged, meaning that returns on comparable mortgaged properties would be higher.
Risks remain, however. Non-institutional-grade properties have been much slower to recover and delinquency rates remain high, especially for properties financed with CMBS at the peak of the credit market bubble in 2006 and 2007. Moreover, a slowdown in the economy could further dampen the leasing market recovery.
A risk that is not top-of-mind in this era of disinflation is what happens when interest rates and cap rates finally rise. With the Federal Reserve contemplating more stimulus measures, interest rates could go even lower before they turn around, especially if euro-related financial contagion triggers a flight to the safety of U.S. Treasuries. But eventually inflation and interest rates will move higher, putting upward pressure on cap rates.
The silver lining is that rising inflation, when it finally arrives, likely would push rental rates and building replacement costs higher, which will help mitigate the upward movement in cap rates. With the Federal Reserve indicating it will maintain its accommodative monetary policy through 2014, rising cap rates are not an immediate concern for investors, although they will present some risk down the road.