Martha S. Peyton, Head of Global Real Estate Strategy & Research
U.S. commercial real estate investment performance accelerated in the second quarter and produced a twelve-month total return of 12%, reversing the decline in momentum that occurred in the first quarter. These solid investment returns occurred in an otherwise dicey economic environment of sagging GDP growth, weakening consumer-spending growth, and ongoing shrinkage in the government sector.
Unlike last summer, when investors faced a series of shocks, the second quarter of 2012 has instead offered a series of disappointments: It is disappointing that the U.S. Congress has been unable to agree on spending and tax policy but rather has kicked the can to the edge of the fiscal cliff. It is disappointing that U.S. businesses have been unable to look past their own discomfort with policy uncertainty to produce more solid job growth. It is disappointing that the eurozone members have been unable to agree on the fiscal coordination required to solve their debt crisis. As a result of these disappointments, consumer confidence and small business confidence remain below their pre-2008 levels, but their volatility has quieted down compared to last summer.
Commercial real estate performance has reaped the benefits of this comparative economic steadiness, even in the face of lackluster growth. For the four-quarter period ended June 30, 2012, the NCREIF Property Index (NPI) posted a 12% total return vs. 13.4% for the prior four-quarter period. During the same period, income returns were steady at 5.9% vs. 6.0% previously, while capital returns tightened to 5.9% from 7.1% posted in the prior quarter.
Investor interest remained concentrated on the highest-quality properties, especially apartments, in major markets, including San Francisco, Boston and San Jose. The weakest performance occurred in metro areas that still face economic challenges, such as Pittsburgh, St. Louis and New Haven, CT. Additionally, commercial real estate has benefited from the sectors of the economy that are doing well, including technology, professional services and business services. The ongoing migration of tenants to higher-quality space is another positive trend.
These sources of return do not appear to be tapped out and can continue to bolster net operating income growth even if macroeconomic growth remains weak. However, there is evidence that stronger growth might be forthcoming, and that evidence supports economic forecasts showing a return to 3% growth by the end of next year. An important driver behind that forecast is the continuing slow healing in the housing sector along with an eventual bottoming-out in state and local government cutbacks. Even if these forecasts prove to be disappointing again, property values can hold steady because disappointing growth will keep Treasury rates very low.
Retail property takes first position
In the second quarter, retail property—the only property type to see returns increase—leapfrogged into first place among the major property types from third place previously. Total returns averaged 13.4% for the four-quarter period that ended June 30, vs. 12.9% for the four-quarter period that ended March 31. Income returns were largely unchanged at 6.4% vs. 6.5% in the previous period, while capital appreciation returns increased to 6.7% vs. 6.1%. Availability rates in neighborhood and community centers inched down to 13% vs. 13.1% previously; however, retailers remained cautious about opening new stores given the uncertain economic outlook. Still, there are signs of improvement, with national inline tenants reporting solid same-store sales growth and strip center REITs reporting stronger-than-expected leasing activity and modest rent growth.
Apartment properties cede pole position
Apartment properties recorded the second-highest total return among the major property types at 13.2% for the four-quarter period that ended June 30, although they slipped from 14.8% for the four-quarter period that ended March 31. Income returns held steady at 5.4%, the same as in the prior quarter. Although capitalization rates (cap rates) edged down slightly to 5.42% for the period vs. 5.44% in the prior period, capital appreciation in the apartment sector was still the highest among the major property types in the second quarter Construction is picking up, with a still-modest 125,000 units expected in 2012, but the pipeline for 2013 and 2014 is growing quickly. The obsolescence of older units and favorable demographic trends will bolster demand for this new inventory.
Industrial sector moves to third place
Industrial property slipped from second to third place among the major property sectors, with total returns of 12.2% for the four-quarter period that ended June 30 vs. 13.9% for the four-quarter period that ended March 31. During the same period, income return fell slightly, from 6.5% to 6.4%, and the capital appreciation return decreased to 5.6% from 7.1%. Fundamentals continued their gradual improvement, supported by GDP growth, a 1.5% increase in industrial production in the second quarter, and still-healthy global trade flows. Cap rates remained virtually unchanged, while net operating income grew modestly for the quarter at 2.5% vs. 2.3% previously. Though vacancy rates remain elevated, new construction remained minimal.
Office sector lags in last place
For the second consecutive quarter, office properties were last among the major property sectors with a 10.5% total return for the four-quarter period that ended June 30 vs. 12.8% for the four-quarter period that ended March 31. Income returns were largely steady at 5.8% vs. 5.9% during the prior quarter. Property values increased, but capital appreciation slowed to 4.6% from 6.6% previously. On a brighter note, the national office vacancy rate fell to 15.7% in the second quarter vs. 16.0% in the first. As with the industrial sector, office rents remain well below the levels needed to justify new construction. In the interim, the lack of large blocks of contiguous space in major markets and the technological obsolescence of older buildings will be the primary factors driving new construction.
The road ahead
In our view, the foundation for solid performance in the commercial real estate sector remains in place over the near term due to a still-improving labor market, ongoing minimal construction, and continued investor interest in the sector. In addition, we believe that the environment for commercial property will be further enhanced over the medium term, as the Fed is likely to keep interest rates low through late 2014 due to the subdued outlook for inflation.
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This commentary is prepared by TIAA-CREF Asset Management and represents the views of TIAA-CREF’s Global Real Estate Group as of March 2012. These views may change in response to changing economic and market conditions. Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Data is as of 06/30/2012 unless noted otherwise.
Real estate investing risks include fluctuations in property values, higher expenses or lower income than expected, higher interest rates which affect leveraged investments, and potential environmental problems and liability.
TIAA-CREF Global Real Estate personnel provide investment advice and portfolio management services through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association. Teachers Advisors, Inc. is a registered investment adviser and wholly owned subsidiary of Teachers Insurance and Annuity Association.
Please note that the index returns presented do not reflect transaction costs or portfolio management fees associated with real estate investing.
Past performance does not guarantee future results.