2011 Fourth Quarter Real Estate Markets Review: Improving Commercial Property Fundamentals

Martha S. Peyton, Head of Global Real Estate Strategy & Research

U.S. commercial real estate investments generated strong positive returns during the fourth quarter of 2011, suggesting that the asset class may have escaped the negative spillovers of the mid‐year economic slowdown. For the four quarters ended December 31, 2011, the NCREIF Property Index (NCREIF‐NPI) returned 14.26%. Income return (which is similar to properties' cash yield) tightened slightly. The return from capital appreciation continued strong but not as strong as in the prior period.

In our view, these results reflect improving commercial property fundamentals, ten consecutive quarters of positive U.S. GDP growth, low Treasury yields and the availability of financing for property purchases. That said, returns moderated a bit from their pace during the third quarter as investors and businesses adopted a more cautious stance in response to U.S. budget uncertainties and the European financial crisis.

Capitalization rates (cap rates), which reflect updated property valuations, tightened for the sixth consecutive quarter on an equal‐weighted basis, while value‐weighted (or market‐weighted) cap rates remain tight even after a small increase. Both are reflective of investor appetite for top‐quality properties.

Apartment market maintains its lead

For the seventh quarter in a row, apartment properties recorded the highest total return among major property types, returning 15.5% for the four quarters ended December 31, 2011. Over the same period, income return declined slightly and the capital appreciation return dropped. Cap rates appear to be reaching a bottom, while net operating income grew 10.8% on the heels of an 11.7% gain during the previous four‐quarter period. Occupancy gains, healthy rent growth and minimal concessions by landlords are driving the increases in net operating income. The pace of new construction remains modest, thereby supporting property values. Although December completions were running at an annual rate of 150,000 units, higher than the 100,000‐unit rate for 2011 as a whole, that pace was well below the 350,000‐plus units delivered annually during the commercial building boom between 2006 and 2008.

Industrials market second place

The industrials property market generated total returns of 14.6% for the four quarters ended December 31, 2011, widening its lead over the office market. During the same period, income return fell slightly and the capital appreciation return decreased. Market fundamentals continued to improve as the sector benefited from positive economic growth and a rebound in global trade flows. Cap rates fell slightly, while net operating income – after 11 consecutive quarterly declines – inched upward. The vacancy rate declined as industrial space was steadily absorbed and new construction remained muted.

Office sector continues strong performance

Office properties posted a 13.8% total return for the four quarters ended December 31, 2011. Income return fell slightly but remained solid, largely because of growth in property values. The sector's capital appreciation return increased. Office cap rates dropped, primarily among central business district properties. Suburban properties remained relatively stable. Net operating income appeared to be on the cusp of turning positive as rents continued to stabilize in most markets and started to grow slowly in others. The national office vacancy rate declined on the back of healthy leasing activity in most major markets. Bright spots include New York, San Francisco and Boston. Meanwhile, office construction continued to fall, supporting prices in the sector.

Retail properties retain their strength

Retail properties provided a total return of 13.8% for the four quarters ending December 31, 2011. Income return over the same period slipped slightly, while the capital appreciation return declined. Cap rates generally held steady, while net operating income rose for the sixth consecutive quarter. Despite a pickup in consumer spending, the vacancy rate remained near 13%, largely because of excess space from the construction boom of 2005‐2008. In the fourth quarter, the construction of neighborhood and community center strip centers was the lowest on record. We expect it to remain constrained because of the difficulty in obtaining financing and the reluctance of retailers to open new stores.

The road ahead

We believe that commercial real estate is in an expansion phase. Although this does not guarantee stellar performance during 2012, we expect limited deliveries of new space, which is likely to support property values. In addition, commercial real estate investments could benefit from improving economic and employment growth. However, there are also negative influences at work, including the struggling residential housing market; shrinking government spending at the federal, state and municipal levels; wrangling over U.S. government tax and spending policy; and the ongoing European debt crisis. These factors have the potential to hamper performance in the months ahead.

To read the full report, click here (PDF).