Principal: NOI Growth Grows More Important

Commercial real estate should benefit from excellent demand fundamentals going forward, predicted Principal Real Estate Investors, Des Moines, Iowa. But declining capital market tailwinds mean that net operating income growth will largely determine value.

“As evidenced by last week’s Federal Reserve rate hike, the positive performance impact that we have all been provided by the capital markets will be less impactful going forward,” said Martin Cropp, senior managing director with PREI.

Cropp said investors must focus increasingly on market- and property-level fundamentals as interest rates increase. “Everyone has benefitted from a lift from the capital markets,” he said. “But now you need to be more precise in asset selection and how you operate properties. Obtaining above-mean returns will hinge on the ability to derive real NOI growth at the property level.”

PREI’s 2016 Commercial Real Estate Outlook recommended that investors show greater selectivity by market, property type and strategy. “The broad ‘beta’ play on commercial real estate may not be as productive as selecting targeted strategies,” the report said. “As such, we recommend a neutral weight to debt and the equity quadrants. However, within each, we tilt towards modestly higher-risk strategies, preferring high-yield debt in non-gateway markets, value-added/opportunistic private equity and selective new-issue commercial mortgage-backed securities.”

The Fed decision to increase interest rates represents a double-edged sword, PREI said. On hand, it marks the ending of a historic period of monetary policy that provided powerful capital market lift for risk assets. On the other hand, it signals the Fed’s increased confidence in the underlying economic environment.

Now that the Fed has started to increase interest rates, “it seems very probable, given the continued uncertainty around the economic outlook, that the Fed is likely to keep a gently upward cycle of monetary tightening,” PREI said.

Overall, PREI said it has an “optimistic” view on earnings growth and total returns next year. “Although 2016 may not be the ‘Goldilocks’ scenario that 2015 was, it should have enough for those investors who view the glass half full,” the report said.