Key Drivers of Commercial Real Estate

Margaret Brandwein, Managing Director, Head of Real Estate Account
Thomas Park, Senior Director, Global Real Estate, Strategy and Research

Click here for the downloadable version. (PDF)

The U.S. commercial real estate market is in the midst of an expansion phase. The market is being driven by a host of factors, including improving commercial property fundamentals, ten consecutive quarters of positive U.S. GDP growth and the availability of mortgage financing for property purchases. In 2012, limited deliveries of new commercial space could further benefit market fundamentals. Moreover, improving U.S. macroeconomic conditions and employment growth could also provide a solid backdrop for the commercial real estate sector this year.

In the following article, Margaret Brandwein, Managing Director and head of the TIAA Real Estate Account (PDF), and Thomas Park, Senior Director of Global Real Estate, Strategy and Research, answer some questions about the commercial real estate market and how direct investment in commercial real estate can fit into a diversified investment portfolio.

What is the current state of the U.S. commercial real estate market?

U.S. commercial real estate market conditions have shown slow but steady improvement over the last 12 to 18 months, generally tracking the economic recovery. Vacancies have declined and rents have grown modestly as employment growth has picked up. Investors continue to show a keen interest in prime properties (i.e., the best buildings in the best locations with long-term leases to financially strong tenants) in the largest metropolitan markets. In these markets, price appreciation has been driven by a limited supply of prime properties and improving economic conditions. In addition, market performance has received a boost from healthy tenant demand, modest rent growth, and the elimination or reduction of leasing concessions such as free rent and tenant improvement allowances.

Market fundamentals have also improved across all property sectors. The apartment sector has been the strongest performer, due to the decline in the U.S. homeownership rate in the wake of the downturn of the single-family housing market. Improvements in the office, industrial and retail sectors have been more modest but significant nonetheless. For example, the recovery in consumer spending has enhanced interest in the retail sector, and particularly in shopping centers anchored by leading grocery chains, market-dominant regional malls, and large lifestyle centers (i.e., shopping centers or mixed-used commercial developments that include traditional retail stores and leisure amenities for upscale consumers). The office and industrial sectors have gained traction with the strengthening of employment growth and global trade flows.

Despite recent gains, we believe there is room for further improvement in property market fundamentals. Vacancy rates have declined in most markets, and they still remain above their long-term averages. However, even though demand is picking up and rents are growing, vacancy rates are still well below the levels recorded in 2007-2008. In addition, construction is modest and likely to remain modest for most sectors for the next several years, as developers and construction lenders remain cautious due to the uncertain economic outlook.

What regions in the U.S. have shown the most growth?

Commercial real estate growth has been strongest in coastal markets, such as San Francisco, San Jose and Seattle. The New York City and Washington, D.C., markets have also been strong but activity has tapered off recently due to concerns about the impact of cutbacks by the banking and financial services sectors and the federal government. We have also seen healthy growth in tenant demand in major markets in Florida. Although investors have been focused largely on major coastal markets, activity has also picked up in secondary markets such as Houston, Dallas, Minneapolis, Phoenix and Atlanta as investors search for opportunities in less pricey markets.

What is your view on Europe and European commercial real estate? Are there specific sectors and/or countries where you see opportunity?

Considerable uncertainty remains over the short- and long-term prospects for the European economy. The sovereign debt crisis appears to have pushed Europe into recession again, and although the recession is expected to be mild, the austerity measures put in place to reduce budget deficits are likely to constrain economic growth for an extended period. In addition, the banking sector, which is hobbled by bad debts and exposure to the sovereign debt of troubled European Union members, has curtailed consumer and business lending, which has exacerbated the downturn. As in the U.S., market fundamentals have improved but remain weak. Investor interest is focused on prime properties in top markets like London, Paris and Munich. The downturn in the European economy has forced some property owners to sell properties in order to generate cash, and lenders have forced others to sell as a result of loan covenant violations. There may be opportunities to acquire top properties at attractive prices as these situations arise.

What are the main advantages of direct investment in commercial real estate?

We believe that diversification is one of the biggest potential benefits. “Don’t put all your eggs in one basket” is an investment adage that has special relevance to commercial real estate because of the sector’s potential diversification benefits. The correlation of commercial real estate returns to stock and bond returns has historically been low or negative. Over the October 1995 to December 2010 period, for example, the TIAA Real Estate Account’s returns had a correlation of 0.06 and -0.11 to stock and bond returns, respectively.

Commercial real estate has historically provided a stable income return over the long term. Income returns from properties owned by members of the National Council for Real Estate Investment Fiduciaries (NCREIF) averaged 5.9% over the 2007-2011 period and 6.7% over the 2001-2011 period.

What is the difference between a direct real estate investment and a real estate investment trust (REIT)?

Direct real estate investment is the ownership of real estate — i.e., ownership of the actual bricks and mortar of a commercial real estate property. A real estate investment trust (REIT) is a company that owns and manages a pool of commercial properties, with an investor owning stock in the company. The shares of most REITs are highly liquid and can be bought and sold in the financial markets. Investor returns are affected by the performance of the real estate properties owned by the company and the short- and long-term fluctuations of the stock market.

What is the outlook for U.S. commercial real estate?

We are cautiously optimistic about prospects for the U.S. commercial real estate market because of the strengthening of the U.S. economy, ongoing improvement in commercial property fundamentals, the modest amount of construction, and the continued strong demand from pension funds, institutions, and foreign investors for commercial real estate. Other supportive factors are the availability of mortgage financing for property purchases and initial cash-on-cash returns that are attractive compared with other investment options. Our optimism is tempered by the run-up in property prices that has occurred over the past year, the potential for expected cutbacks in U.S. government spending to slow economic growth, and the potential spillover effects from an escalation of the European debt crisis on the U.S. and global economy.

Do you have any take-away points for investors?

Commercial real estate is a large and diverse sector of the economy that individual investors have often overlooked because of a lack of direct access to the asset class. We believe that direct investment in commercial real estate is most appropriate for investors with a long-term investment horizon. However, commercial real estate markets can be volatile depending upon economic conditions and construction cycles.


1. Correlation is a statistical measure that indicates how closely together the returns of two assets move over time. An asset class is considered a good portfolio diversifier if its correlation to the returns of other asset types in a portfolio is low or negative. Correlations range from -1.0 to 1.0. A correlation of 1.0 indicates that the assets’ returns move together in unison. A correlation of -1.0 indicates that the assets’ returns move in opposite directions.