Where in the Cycle Are We?

Several factors can give commercial real estate practitioners reason for optimism, but there are reasons for concern, said Green Street Advisors, Newport Beach, Calif.

“The economy is doing pretty well, and barring a trade war, economic growth is expected to pick up this year and next as the twin engines of tax cuts and deficit spending take effect,” said Green Street Senior Analyst Joi Mar in a special report, Are Cap Rates Heading Up? “On the supply side, low supply growth has been one of the defining positive attributes of this real estate recovery and new supply has been problematic in only a few sectors and markets. With supply and demand roughly in balance, we can expect inflationary-type rent growth for the near future.”

But steady average rent growth can mask wide variations across property sectors, especially between the strongly performing industrial sector and the hard-hit retail sector, Mar cautioned. “Most property sectors except for retail are seeing some level of rent growth,” she said. “Secular changes triggered by e-commerce are helping industrial real estate, especially infill properties, and hurting the retail sector.”

Green Street calculates market revenue per available foot across different property types by combining changes in rents with changes in occupancies. It expects annual market revenue per available foot growth to be between -1 percent and 5 percent annually over the next five years, with strip retail centers at the low end and industrial real estate at the high end.

“Overall, fundamentals are healthy but slowing and there are definite winners and losers between property sectors,” Mar said.

Nominal cap rates in most property sectors appear to be increasing slightly, Green Street said. “Bid-ask spreads have widened and investors are more hesitant to buy and sell in light of slowing operating fundamentals and a fear of rising interest rates.” Mar noted commercial real estate transaction volume has fallen year over year and would be even lower if not for “extremely accommodative” debt markets.

Green Street compared real estate to corporate bond markets. In the past an investor typically garnered 150 extra basis points in yield by investing in real estate compared to investment-grade corporate bonds. “Today, that spread is right on top of its long-term average, suggesting that real estate is fairly priced compared to investment-grade bonds,” Mar said. “A comparison of real estate pricing to high yield bonds sends a slightly more upbeat, though similar signal.”

The report also studied public real estate investment trusts because the REIT market can give a good prediction of future private market asset values–if REIT stocks trade at big discounts to the value of their assets, private market asset values tend to fall and if REITs trade at large premiums, private market asset values tend to rise. “Today, REIT shares trade at fairly sizable discounts to underlying asset values, so the REIT market is saying real estate is expensive–a different signal from the corporate bond market,” Mar said.

“To tie this all together, the corporate bond market says real estate is fairly priced, while the REIT market says it’s expensive,” Mar said. “Green Street believes real estate pricing is probably a little stretched, with values expected to trend slightly lower and cap rates continuing to inch higher over the next six to 12 months. Net operating income growth will offset some, but not all, of that cap rate move.”