In the past month, many of the green lights on the economic dashboard turned red. Most economists agree that we are unlikely to slip back into recession any time soon, but growth will remain below potential for some time and risk levels will remain elevated.   The traditional investor demand for higher yields given the higher risk isn’t playing out as one might expect. A record volume of capital on the sideline has rushed into high-quality commercial real estate over the past 18 months, resulting in a dramatic re-compression of yields at the upper-end of the market. True distressed opportunities via conventional fire sales by government agencies or lenders have been limited to low-quality assets in weak areas. As expected, there is no RTC 2 anywhere in sight. So, what is the best strategy for CRE investors?

To start with, overreacting to the recent loss of economic momentum would be unwise.  For every piece of bad news or negative reading, there are positive data points as well.  For example, retail sales in the U.S. excluding auto and gas sales, are up 5.2% on a year-over-year basis. Energy prices have eased considerably and corporate profits remain strong. Exports, which contribute more than four times to the economy than the for-sale housing market, are growing at a healthy pace. And last but not least, we have added more than 1.8 million net new jobs and 2.1 million private-sector jobs since the bottom of the recession. The yield curve (difference between short-term and long-term interest rates) is far from a recessionary reading.  At least some of the recent slow down in global growth can be attributed to the tragedy in Japan which disrupted supply chains in many industries. There are four major factors that real estate investors should keep in mind:

  1. There will be demand for commercial real estate. Over the next three years, average growth in the United States (assuming a typical recovery jolt from a harsh recession to above average growth is erased by higher taxes and lower spending) will conservatively translate to 4.5 million to 5 million jobs. That won’t be enough to dramatically reduce the underemployment rate, but it will result in recovering a large portion of the 8.4 million jobs lost in the recession, especially if we account for the near 2 million net jobs already added since the trough. All property sectors have already bottomed, and are in a moderate recovery mode with apartments leading the pack and deep into a strong recovery.
  1. New supply will remain in check for an extended period. The reduction in rents and occupancies and gradual nature of the recovery will not justify new construction in most markets and property sectors for at least the next two to three years. Apartments are the only exception and may see pockets of increased construction, but at a macro level demand should outstrip new supply across the board for several years, allowing occupancies and rents to recover.
  1. Lock in low interest rates ahead of rent growth for a compelling hedge. The silver lining to current headwinds and renewed fears about the economy is lower interest rates. With the 10-Year Treasury yield around 3%, investors can create a safety net by locking in today’s historically low interest rates. Waiting until the recovery in fundaments gains full momentum will most likely mean higher prices for the asset and higher interest rates. The current combination of low interest rates and cap rates also make CRE a competitive asset class compared to alternative investments, especially the volatile stock and corporate bond markets.
  1. Blending core asset holdings with a move down the quality chain should pay off. Many investors are now considering Class B, B- and value-add investments in search of yield. Despite short-term economic weakness, the long-term supply/demand outlook and low interest rate-environment support this strategy as long as selections are made wisely and underwritten well. This is especially true for value-add opportunities where the required rent levels have to be achievable. Over-improving a property was a painful lesson for many investors during previous recoveries. At the same time, smart money is paying a premium for top- tier assets in the best, supply constrained locations and looking past the going-in cap rate, betting that out-sized rent growth and future capital demand for these assets will pay off. The key ingredients are supply constrained and out-sized rent growth. To the degree these forces are realistically underwritten, buying core assets still pencils out in many cases. 

It goes without saying but sector selection, market selection, creativity and timing still rule when it comes to a winning acquisition strategy.  Look for more on these factors in our future blogs.

 

Hessam Nadji is managing director, research and advisory services, for Marcus & Millichap Real Estate Investment Services. Contact him at hessam.nadji@marcusmillichap.com.