Commercial property values have risen steadily over the past few years despite weak fundamentals across geographical markets and property classes. It now appears that two factors — real estate's solid yields and its perception as a safe haven investment — enabled values and vacancies to rise in lockstep.

That disconnect is driving concerns of a correction, especially as interest rates begin to creep back up. Yet even with higher interest rates, property values should remain strong and relatively stable.

In a typical recovery, the economic expansion triggers a profit rebound and higher stock prices. That, in turn, causes a capital shift. While the first phase of this recovery began last year, buyer demand for real estate did not slow down. And so far this year, stocks have been volatile and generally flat. The result? Investor demand for real estate has increased despite higher interest rates.

Rising Economic Tide

Real estate has also gained credibility throughout this cycle, and it should continue to lure domestic and foreign capital despite lower short-term returns. Investor demand has so far outstripped the supply of for-sale property. Even if demand falls a bit, the sellers' market isn't likely to falter.

If the Federal Reserve can keep a lid on inflation while gradually raising interest rates, the higher cost of capital will be accompanied by improving occupancies and rents, which will support buyer demand and pricing in general.

The market — and pricing — also is supported by several other factors. Given the volatile stock market and global uncertainty, investors now have a newfound respect for real estate's stable, bond-plus-type performance. Many private investors are participating in the market and even competing in arenas once solely the province of institutional investors.

The United States is entering a new expansion cycle with favorable projections for demographics and job growth. Aging baby boomers, driven by the need for cash-flow investments and wealth preservation, will continue to eye real estate. Institutional investors are in a similar situation in terms of cash-flow obligations and should increase their real estate allocations over the next several years.

Property Class Differences

The availability of capital and the willingness of lenders to do deals are keys to real estate transactions, and any disruption would greatly impact the market. Certain markets and property types are riskier than others, of course. A glut of office and apartment construction could pose a risk in some markets while markets with lagging local economies are vulnerable to the effect of higher interest rates.

Among property sectors, retail has maintained the best fundamentals, thanks to strong consumer spending and restrained construction. These factors have helped to spare the sector from a sharp rise in vacancy experienced by other property sectors. Last year, vacancy increased just 20 basis points to 10.5%, and the increase is likely to be erased this year due to strengthening tenant demand.

The apartment market will see signs of improvement based on growing tenant demand that will be fueled by returning job growth, a leveling off in home buying and favorable demographics. However, corrections in vacancy will be gradual in the near term due to ongoing construction.

Office properties face a longer recovery period since absorption of space tends to lag economic improvement. Also, leases signed in 2000 and 2001 will be renewed at lower rates in many markets. However, higher cap rates and a projected strengthening recovery by 2006-2007 present a buying opportunity in many markets.

Against that backdrop, it may be high time for owners to assess their return on equity and diversify by moving into different property types and geographic markets. Buyers still have the advantage of low interest rates preceding a new wave of employment and demographic expansion, and that strategy should pay off for both value-added transactions and longer-term investments.

There may also be less competition for properties as some leveraged buyers withdraw from the market, assuming interest rates rise by 100 basis points over the next 12 months. However, plenty of equity capital is ready and willing to fill the void. The strength of the capital markets should continue to support asset values, while improving conditions in the space markets over the next two to three years will allow fundamentals to catch up with values.

Harvey E. Green is president and CEO of Marcus & Millichap Real Estate Investment Brokerage Co.

NAREIT Equity Index Outperforms Other Indices

Historical compound annual total returns of the NAREIT Equity Index
vs. the leading U.S. benchmarks. Data for period ending June 30, 2004.
NAREIT Equity S&P 500 Dow Jones Industrial Average*
1-Year 27.1% 19.1% 16.4%
3-Year 15.4% -0.7% -0.2%
5-Year 14.5% -2.2% -1.0%
10-Year 12.1% 11.8% 11.2%
30-Year 14.6% 12.7% 8.9%
*Price-only returns.
Source: NAREIT