Here are the four questions I’m most frequently being asked by commercial real estate investors these days, and my answers:
1. Are rising interest rates going to kill the commercial real estate investment market?
No, not in the least. First of all, interest rates cannot stay at near-historic lows forever. Real estate investment has thrived in all sorts of interest rate environments, even during periods of very high inflation and rates of the ’70s and early ’80s. Higher rates mean higher inflation for rents and capital values as well as an initially higher cap rate—a good thing for buyers.
The Federal Reserve’s benchmark rate averaged 2.96 percent in the first decade of the 21st century as opposed to 5.15 percent in the ’90s. The general view is that rates will remain low by historical standards due mainly to the fact that our economy is expected to remain in slow growth mode. A slower growth rate will mean a lower real interest rate. While interest rates can significantly affect the cost of financing and mortgage rates, which in turn affects property-level costs, influencing values. However, supply and demand for capital and competing investments have the greatest impact on cap rates and investment values. The supply and cost of capital affect not only demand but also the amount of capital available for real estate purchase and development.
While rising interest rates can reduce the value of future cash-flows, inflation can in turn increase the value of physical property due to the fact that real estate is a hard asset. Ultimately, if the increase in property value from inflation outweighs the decrease caused by rising rates, the net result can be positive. This fact has made real estate one of the most sought after investment classes in periods of rising rates because of its ability to weather the storm of inflation.
As interest rates never change alone, it is useless to analyze the potential effects on real estate value without thinking about other contributing factors. When it comes to real estate, the relationship between inflation and rising interest rates becomes more complex. Inflation is often the critical driver of interest rates, and as such the two typically move together. While rising interest rates can reduce the value of future cash flows, inflation can in turn increase the value of physical property due to the fact that real estate is a hard asset. Ultimately, if the increase in property value from inflation outweighs the decrease caused by rising rates, the net result can be positive. This fact has made real estate one of the most sought after investment classes in periods of rising rates because of its ability to weather the storm of inflation.
2. Isn’t physical retail a dinosaur destined for extinction because of the rapid growth of online shopping?
Heavens, no! Reports of the death of physical retail have been greatly exaggerated. While online shopping continues to register double-digit growth, physical retail is still going strong in many places. While economic growth and housing markets will determine the future of some retailers and retail platforms, it is becoming clear that brick-and-mortar retailers will be forced to change their business models, incorporating e-commerce into their marketing and physical space portfolios. Most consumers still enjoy onsite retail, yet more and more are finding their purchasing needs satisfied online, which promises delivery to one’s door within a day or two. As a result, many, if not most, retailers are becoming part physical showroom and part online sales as consumers browse the physical store only to return home to complete their purchases online. More successful retail models are those that focus on necessity retail, such as those anchored by groceries and drugstores.
Many successful retail centers have remained relevant by improving the quality of their environments—making retail shopping a more interesting and pleasurable experience. Another trend that is the move away from goods to the selling of services such as restaurants, medical clinics, fitness centers, spas and pet services. These retail formats are difficult if not impossible to provide online—have you ever tried eating a hamburger online? As Americans find themselves having to work longer hours to maintain their standard of living, these services found at the local retail center will become increasing important.
3. I keep hearing about the ‘wall of capital’ inundating commercial real estate investment. Is this trend going to spell disaster in the next market downturn and recession?
Real estate has become a very popular asset class in the U.S. and globally. Part of this is the search for higher yields, a hard asset class and low correlations. Moreover, real estate has delivered outstanding performance over the last five years. It can be argued that there is an over-supply of capital globally. Populations are aging and many investors seek safer investments such as real estate rather than riskier assets and strategies. Moreover, the growth rates for developed countries have slowed so there are fewer high return investment opportunities in general. Added to this are emerging market countries, producing enormous piles of cash from their expanding economies. China is a poster child of this phenomenon, as it actively seeks to diversify that capital into a safe haven country such as the U.S. The result has been that prices of commercial property assets now in low single digit cap rates in many U.S. gateway cities. Cap rates and peak prices have broken new records in these cities, never a good sign.
Nevertheless, fundamentals are good and in fact improving, so in many cases, the quality of the underlying real estate is good and a high price in part reflects the prospect of good future performance. Supply is still below historical levels in most metros and demand is rising in every sector. Leverage ratios are still not near the dangerous levels achieved in 2005-2007 and underwriting has not deteriorated significantly yet.
The continued slow growth of developed countries seems to be a long-term trend, forcing capital into more conservative and yield-oriented investments such as real estate and bonds. The growth of economies with high savings rates and a shortage of both mature financial markets and safe assets—like China—suggest that capital will seek a safe home for some time now.
4. Is office space a defunct real estate sector? After all, demand is shrinking because of smaller and more shared work spaces and more people are hot-desking or working remotely.
While it is true office space has been undergoing a major transformation over the last decade and particularly since the Great Recession, the demand for office space is now rising in many parts of the country on the back of rising service employment. It is more accurate to say that nature and type of office demand is changing. While CBD office remains strong, suburban traditional office is lagging. Firms want new office space that is designed along sustainable lines and modern work place trends—natural light, free-flowing spaces and plenty of meeting spaces. Many firms are moving from their suburban campuses to urban locations. Technology and demographics are playing a bigger role in shaping the demand for commercial real estate than they have for decades. Workplace strategy clearly impacts the design of new and existing office spaces, a trend that is well researched. However, less well documented are the economic advantages of location.
Attraction and retention of talent is key, and research suggests that this talent—especially the millennial generation that will gradually begin to dominate the workforce—demands walkable, active, mixed-use environments. At the same time, firms that have elected to relocate have been pushed by the obsolescence of the design of their existing spaces. Owners of property will need to consider location of workspaces, and the role of technology and demographics in the design, lest the obsolescence of specific buildings translate into permanent obsolescence of a once prominent location.
These and other questions are answered in greater depth in my new book, The Investor’s Guide to Commercial Real Estate (ULI, $124.95), which describes the strategies, markets and sectors that astute investors need to know.
David Lynn, Ph.D., is CEO of Everest High Income Property, based in San Francisco and New York City. Visit his website at www.everesthip.com.