Image source: Getty Images
Optimism is back for commercial real estate. Property performance through the third quarter reflects considerable gains for real estate investors, while interest rates and inflation are of limited concern to the asset class.
Investment returns for institutional-quality property hit a 15-year high in the third quarter of 2021, according to the National Council for Real Estate Investment Fiduciaries (or NCREIF). NCREIF tracks institutional-quality commercial property and fund performance using data provided by its investment management members.
The NCREIF Property Index (NPI) total return for the third quarter of 2021 was 5.2%, which is the combination of a 1.0% income return and a 4.2% capital return (or appreciation). The last time the NPI quarterly total return was over 5% was in the fourth quarter of 2005. For context, the 20-year average quarterly total return is 2%.
Third quarter 2021 commercial property performance was stunning. But, it is also impressive given the very short and shallow depreciation cycle in 2020. Depreciation as measured by the capital return, lasted only two quarters (first and second quarters of 2020) and resulted in cumulative depreciation of only 2.7%. As a result, commercial property values in the NPI are already 5% above their pre-pandemic peak.
Rents were under pressure early in the COVID-19 pandemic when tenants were returning space to the market for sublease or delaying new leases. In 2021, the economy is roaring back. Economic growth is proceeding at its strongest annualized pace in 15 years too. Plus, as of November 2021, 18.5 million jobs have been recovered out of the 22.4 million lost during the pandemic.
What about interest rates?
In 2022, interest rates will likely edge up as the Federal Reserve completes their tapering of asset purchases. It is possible that the federal funds rate could be raised in 2022, but this would be a data-driven decision based upon continued strong growth in the economy.
More growth is good for real estate, but higher interest rates can impact values through capitalization (cap) rates. Cap rates measure property income as a share of market value. For NPI properties, cap rates on current valuations have averaged an historically low 4% from second quarter 2020 through third quarter 2021.
Although the cap rate is low, the cap rate spread to the 10-year U.S. Treasury yield is wider than its long-term average. The 20-year historical average cap rate spread the the 10-year Treasury is 250 basis points (bps), compared to 266 bps in the third quarter of 2021 and a trailing year average of 275 bps. A wider spread indicates that commercial property can offer better yields and makes it possible that the spread could compress, as opposed to cap rates rising, in response to higher interest rates.
What about inflation?
Inflation is the reason interest rates are expected to rise, but it is also a driver for capital flows into real estate. Commercial property is considered a hedge against inflation because rents paid to owners tend to rise with general price levels, supporting returns during inflationary periods. For non-income producing assets, inflation can serve as a drag on performance.
Economic growth thus far has driven this commercial property performance, and the recovery isn’t even over yet. At this point in the real estate cycle, there are opportunities to capitalize on rising rents, rising demand for space, or - depending on the specific property - both.
