Asset Management

2011 Third Quarter Real Estate Market Review: Performance Minimally Impacted by Financial Market Volatility

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

The financial markets were marked by sharply higher volatility during the third quarter 2011, reflecting the combined effects of slowing economic growth, Europe’s sovereign debt crisis and the political debate about raising the U.S. debt ceiling, which was followed by the downgrade of U.S. government debt by Standard & Poor’s Ratings. Overall, U.S. Treasuries remained the safe haven of choice for many investors.

U.S. commercial real estate investment performance was only minimally affected by the turmoil in the financial markets and uncertainties about economic growth. For the four quarters ended September 30, 2011, the NCREIF Property Index (NCREIF-NPI) returned 16.1%. Of that total return, the income return was 6.3% and the capital appreciation return was 9.4%. (Income return measures the portion of the total return attributable to each property’s net operating income. The capital appreciation return measures the change in market value adjusted for any capital improvements/expenditures and partial sales.)

Although these results were dramatic, they are – because of the appraisal methodologies that produced them – backward looking. More timely information is contained in the subset of NCREIF-NPI properties that changes hands each quarter. The capitalization rates (cap rates) for these properties widened slightly from 6.51% in the second quarter to 6.55% in the third quarter. More importantly, the spread between these cap rates and the 10-year Treasury yield widened significantly – from 332 basis points in the second quarter to 415 basis points in the third quarter. (A property’s cap rate is the ratio between its net operating income and either its original purchase price paid or its current market value.)

And yet, while commercial real estate investments did not experience intense volatility during the third quarter, the asset class is not immune to the economic challenges that affect the financial markets. Weak U.S. economic growth is prolonging the recovery in net operating income and the occupancy rates of industrial and office properties. Furthermore, the risk of weaker 2012 economic growth could further slow the pace of recovery, especially within the lagging office sector. Even 2.1% U.S. GDP growth, as estimated by the Blue Chip consensus (an average of 54 private sector economic forecasts) is a weak foundation for a commercial real estate recovery. However, there was a small amount of construction activity at the end of the third quarter, which suggested to us that even weak economic growth might restore equilibrium to the space market.

Apartment Market Continues to Lead

For the sixth consecutive quarter, apartment properties posted the highest total return among the major property types, returning 18.6% for the four quarters ended September 30, 2011. The income return for the same period was 5.6% and the capital appreciation return was 12.5%. Cap rates have declined slightly, which could mean that the apartment market is reaching a bottom. Occupancy gains, healthy rent growth, and minimal concessions by landlords are driving increases in net operating income. Construction is also rebounding off the lows recorded in 2009-2010.

Industrials Market Moves into Second Place

The industrial property market generated total returns of 15.4% for the four quarters ended September 30, 2011, pushing its performance into second place behind the apartment market and ahead of the office and retail markets. Income return was 6.7% while the capital appreciation return amounted to 7.5%. Fundamentals in the industrial real estate market have slowly improved and we believe further gains are likely if the economy continues on its slow growth trajectory. Cap rates have declined and net operating income appears to be stabilizing. Although the vacancy rate has moderated slightly, industrial construction is stuck at historic lows.

Office Sector Performance Remains Strong

Office properties recorded a 15.3% return for the four quarters ended September 30, 2011. Income return slipped to 6.2% from 6.5% in the previous four-quarter period ended June 30, 2011. We believe the dip in income return was largely because of growth in property values. Supporting our view was a capital appreciation return of 8.7%. Cap rates dropped despite seven consecutive quarters of declining net operating income. However, rents have stabilized in most markets and are growing slowly in others. The national office vacancy rate held steady at 16.2%, while office construction dropped, approaching the historic lows of 1993-1994.

Retail Properties Continue to Show Strength

Retail properties provided a healthy total return of 15.3% for the four quarters ending September 30, 2011. Of that total return, income return was 6.7% and capital appreciation return was 8.2%. Cap rates declined slightly while net operating income was up for the fifth consecutive quarter. The vacancy rate remained elevated; it has been near 13% since 2010, largely because of anemic consumer spending and a space surplus. Retail construction continued to be constrained by financing difficulties and retailers’ reluctance to open new stores in weak economic conditions.

Looking Ahead

In the coming months, we expect commercial real estate investment performance to benefit from the recovery in NCREIF-NPI property values, improving commercial property fundamentals, nine consecutive quarters of GDP growth, continuing low Treasury yields and available financing for property purchases. Among the possible negative influences: impediments to the economic recovery, such as anemic job growth, the moribund housing market, and shrinking government spending at the federal, state and municipal levels, as well as global pressures such as the European debt crisis.