Investors face a conundrum in today’s market: Low interest rates are making fixed-income products less attractive, while broader equitiescontinue to be volatileamid weak global economic growth, ongoing geopolitical turmoil and depressed commodity prices.
“People are desperately seeking yield and having a very difficult time finding it,” saidChris Ludeman, global president of Capital Markets atCBRE Group, a commercial real estate services and investment firm.
One asset class many are considering is commercial real estate, with its potential to offer more stable, higher-yield returns over the long term. While commercial real estate also has risks — and has been affected by volatility and negative investment sentiment in recent months — its fundamentals remain strong, according to Ludeman.
“Commercial real estate continues to provide attractive risk-adjusted returns in a low-interest rate, low-return environment,” he said. “In most instances, you’re dealing with good corporate credit and longer-term leases in markets where new supply is limited,” leading to more sustainable, predictable yield, he added.
Ludeman forecasts returns in the commercial real estate sector will continue rising in the years ahead. At the same time,structural changeswill lead to evolution in the office, retail, industrial and multifamily segments. These changes include a growing preference for renting over buying in the aftermath of the U.S. housing crisis (resulting in greater multifamily demand), and a rise in e-commerce sales that is reshaping the traditional retail and industrial space.
The office market is also evolving, as companies tailor their spaces and locations to better suit the needs of employees, including more collaborative layouts and sites closer to public transit routes.
Based on CBRE’s current analysis, Ludeman expects the economic expansion and commercial real estate cycle to continue an upward trajectory into 2018.
Supply Constraints Drive Demand
The U.S. housing crisis a decade ago, followed by the global financial crisis in 2008-09, slowed spending across industries, and commercial real estate was no exception. Today, as the global economy picks up, led by job growth and increased consumer activity in the United States, demand for all types of commercial real estate has increased.
“We are seeing record rents, record sales volume and record values,” saidSpencer Levy, Americas head of Research at CBRE. “Our forecast is for a good performance at least for the next several years.”
In particular, Levy forecasts rents will rise between 4 percent and 5 percent in retail, office, industrial and hotel, and between 2 percent and 3 percent for multifamily units, or apartment buildings. Although rental growth may be slower in multifamily, the segment is growing — a trend that is expected to continue for years to come.
As the economy began to expand in 2012, multifamily and industrial asset classes became validated as institutional asset types and attracted interest from global capital investors, who added liquidity and demand to the market.
The multifamily phenomenon has been driven by changing demographics and the shocks from the global financial crisis. “There has been a structural shift in the percentage of renters versus buyers,” Levy said.
Renting is becoming “the new normal,” according toa reportfrom the Urban Institute, which forecasts that new renters will outnumber new homeowners in the next 15 years, “causing a sustained surge of rental housing demand.” The report predicts that 59 percent of the 22 million new households formed between 2010 and 2030 will rent, compared to 41 percent that will buy. Multifamily real estate is already one of the fastest-growing segments of the U.S. real estate market, hittinga record $43 billionin the fourth quarter of 2015.
“The market can sustain more building today than it might have, say, seven or eight years ago,” Levy said. “That’s the fundamental story.”
Cautious Outlook
Still, there’s caution in the market, withsome investorsnervous about pulling the trigger on new deals, Levy said. Some of that cautious sentiment stems from concerns about China’s debt problem and volatile oil markets.
Another potential risk is rising interest rates. All eyes are on how far and how fast the U.S. Federal Reserve will raise rates in the weeks and months ahead. Traditionally, rising interest rates are considered a negative for real estate investors because the cost of borrowing rises. But it’s not always the case.
Levy points to the so-called “taper tantrum” in the spring and summer of 2013, when the 10-year U.S. Treasury note went from 2 percent to 3 percent over a three-month period, and cap rates remained stable.
“We believe there’s some room in there for cap rates to stay stable even in the phase of rising rates,” Levy said, adding that the yield on the U.S. 10-year Treasury note is already very low, at about 1.8 percent, and the spread between the 10-year Treasury and cap rates remains wide by historical standards.
On the flip side, rising interest rates can also be interpreted as a positive for the commercial real estate market, because they reflect stronger economic activity.
“So much of our business in commercial real estate is built around job growth and the consumer,” Ludeman said. That, in turn, affects retail space as well as manufacturing, including filling of warehouse, imports and exports as well as office and hotel occupancy rates as business activity increases.
“So we have a kind of virtuous cycle around the supply chain of the global business environment,” Ludeman said.
While interest rates will eventually go up, they are likely to remain stable, on a relative basis, and rise gradually over the longer term, according to Ludeman.
“As long as there’s predictability in the capital markets, and there are not high levels of volatility, I think a gradual rise in interest rates won’t be detrimental to the business,” he said.
Althoughvolatility and uncertainty will continue in the global markets, and commercial real estate isn’t immune, the fundamentals of the business continue to be strong.
“It’s not just money chasing assets,” Ludeman said. Commercial real estate is providing positive risk-adjusted yields — “not necessarily just through cap rate compression, but around [improving] property level performance,” he added.
To learn more about navigating today’s global capital markets, download CBRE’s Thought Series, Leading Global Capital in a Time of Uncertainty.
