Investors Still Like CRE

Commercial real estate has become more attractive from a return vs. risk perspective, but opinions about risk-adjusted returns vary significantly by property type, reported Situs RERC, Houston.

The company’s Under Pressure report asked institutional investors to rate commercial real estate returns and risk compared to other investment options on a 10-point scale. Respondents also rated individual CRE sectors.

Institutional respondents said returns now outweigh risk in the overall commercial real estate market for the first time since second-quarter 2017. Respondents gave overall CRE a 5.2 return vs. risk rating, up from 4.8 the previous quarter and 4.7 a year ago.

“The return vs. risk rating has been on an upward trend for almost a year, an encouraging sign,” the report said. “For perspective, the return vs. risk rating was at or above average for nearly eight years prior to the second quarter of 2017.”

Situs RERC said long-term real estate yields remain attractive compared to alternative investments. “However, institutional investors are concerned that the potential for future rising short-term interest rates could eat into risk premiums,” the report said.

Situs RERC also studied CRE’s value vs. price rating. That figure declined from 4.6 in the second quarter to 4.3 in the third quarter, remaining below average. This indicates commercial real estate is overpriced relative to its value, the report said. “The rating has not been this low since late 2008 and is considerably lower than the post-recession average of 5.1,” the report said, noting the value vs. price rating has generally trended downward since late 2015 and respondents have rated the CRE market as overpriced since early 2016 except for a brief spike in late 2016.

“Investors are concerned that prices are getting ahead of market fundamentals,” the report said. “One institutional investor stated that there may be a potential weakness in future net income growth due to rising expenses and potential capital expenditures that could be exaggerated by any rise in cap rates.”

The report also compared return vs. risk for the major property types. The industrial sector’s return vs. risk rating increased slightly quarter over quarter, remaining above average at 5.7, which indicates returns outweighed risk in this sector. “The industrial sector has consistently been among the highest-rated sectors from a return vs. risk perspective,” the report said. “In most quarters since the global financial crisis, it has been the highest-rated sector. There has been a general down­trend in ratings since late 2015, but the rating has remained above average since 2009.”

The return vs. risk rating for office assets improved from 4.6 in the second quarter to 5.1 in the third. “The return vs. risk rating generally declined from early 2015 to third-quarter 2017, but has recently shown signs of an upward trend; return and risk are more closely aligned for the office market,” the report said.

The report noted the retail sector’s return vs. risk rating rose from 4.3 in the second quarter to 4.9 in the third. But the retail sector had the second-lowest return vs. risk rating despite the improvement and beat only the hotel sector. “Investors may be becoming more optimistic about the retail sector; its return vs. risk rating has improved over the last two quarters,” Situs RERC noted.

The apartment sector’s return vs. risk rating declined slightly, from 5.4 in mid-2018 to 5.3 in the third quarter. After a steady fall in the ratings between 2012 and 2016, the return vs. risk ratings grew more volatile over the past two years. “Since third-quarter 2016, investors have mostly seen return outweigh risk in the [multifamily] sector,” the report said.

For hotels, the Situs RERC return vs. risk rating slipped from 5.0 in the second quarter to 4.8 in the third. The close to the mid-point rating indicated the sector’s return and risk are close to equilibrium, but well below the post-recession peak of 6.4 in late 2010. The sector’s rating has seen a generally downward trend since early 2014.