While the Federal Reserve decided to sit tight on an interest rate increase in September, that decision was based primarily on low inflation and global jitters.
Strong employment trends in the US continue to bolster office and rental housing demand and low oil prices have contributed to gains in consumer spending, solidifying retail and industrial sector performance.
Total returns for commercial real estate are on track to register a sixth consecutive calendar year of double-digit performance since the GFC, based on the NCREIF Property Index.
Forecasters are affirming these positive prospects; the latest (2Q15) consensus survey by the Pension Real Estate Association in the US shows continued strong above-average growth for 2015.
Viewing the cycle in context
Given the strength of the recent recovery there is increasing speculation about whether we are reaching the top of the cycle.
It’s natural to speculate but also important to note that real estate cycles have no schedule; they do not die of old age. Furthermore, fundamentals are quite different than they were in 2008, especially given that most properties are held with much lower levels of leverage.
We have seen enough debt availability to support commercial property transactions, but not so much to create pervasive pricing or debt bubbles. Other factors that define the current cycle include low interest rates, declining vacancy rates, rising rents and modest new construction.
Given today’s pricing, we believe that the benefit from cap rate compression is likely to continue to diminish.
Despite low cap rates (initial yields), cap rate spreads over 10-year Treasuries are above their long-term average (300 bps) suggesting that real estate continues to offer good relative value and the potential for further, albeit modest, cap rate compression.
As the cycle continues to mature, net operating income (NOI) growth is expected to become the primary driver of property investment performance.
The interest rate factor
We have also heard some investors voice a concern that the eventual rise in interest rates will result in higher cap rates and declining property values.
These fears are only justified if everything else is assumed not to change.
While this assumption might seem reasonable, it oversimplifies the more complex nature of reality and ignores factors that have the potential to offset value declines.
These factors include common underwriting exit assumptions, the length of the investment horizon, and the benefits of compounding annual NOI growth.
We believe that stronger NOI growth is likely to accompany rising interest rates because the Federal Reserve has vowed to raise rates only if the economy is strong enough to tolerate it.
Put simply, higher interest rates are an outcome of a buoyant economy, and this flows through to buoyant rental income.
An uptick in supply
With the current US real estate environment characterised by solid performance, strong capital flows, and expanding debt availability, conditions are ripe for new supply.
New construction is likely going to be the key differentiator of market performance in the next phase of the cycle, and is why our target market strategy gives preference to supply-disciplined markets.
Vacancy rates across the four major property types are currently near long-term averages and new supply has generally been constrained.
New construction has been percolating in the apartment sector, and with expected new supply, apartment fundamentals will likely moderate but maintain attractive levels.
In terms of demand for this stock, we believe that economic, employment, and demographic trends should that bolster rental housing demand.
Gateway cities in focus
In terms of TIAA-CREF’s portfolio in the US, we remain focused on gateway cities on the coasts, and the four major groups of office, retail, industrial and multifamily.
We have also recently started investing in purpose-built student housing in the US as we believe it offers attractive yields and risk profiles.
While many major cities appear fully priced right now – and by some measures they certainly are – the durability of their returns and the liquidity they provide continue to make them appealing.
For instance, New York, by historical means, would be considered expensive, but relative to the risk-free rate and relative to US treasuries, there is still a meaningful spread on both the cap rate and the discount rate.
New York, San Francisco, Washington DC and Boston are examples of very tight, infill gateway cities that have supply constraints, strong employment and demographic growth, all of which are key to durable, long-term returns.
They also tend to be able to take a punch during a downturn a lot better than the secondary and tertiary markets.
Assets that match the strategy
In today’s market, competition is a factor. We are in the fortunate position of having long-term relationships in the industry and seasoned staff to source deals, but that doesn’t alleviate the issue of bidding becoming overheated.
One of the most fundamental things to look at is the price of an asset versus replacement cost.
We watch where we are buying in terms of the rent profiles and where they are relative to history.
However, we are most comfortable if we are buying at below-replacement-cost and when rents are lower than in the past.
The best purchaser is a well-informed investor. Top-down research, combined with local, on-the-ground insight gives us a clear strategy and vision.
Our objective is to identify singular properties that complement our strategy, rather than attempt to deploy capital as quickly as possible.
Although competition may heat up prices even when the markets are down, your own performance metrics will indicate how far you are willing to go and what makes sense in the context of your portfolio.
That is especially important in today’s environment, and the same philosophy applies no matter the region.
Having experienced three full cycles in my career, I’ve learned not to try to time the market, but rather to have a smart, diversified strategy that can weather the storms.
Phil McAndrews is senior managing director and chief investment officer of TIAA-CREF Global Real Estate.
