DIVERSIFYING YOUR COMMERCIAL REAL ESTATE PORTFOLIO: WHY and HOW
Commercial Real Estate (CRE) investment provides savvy investors a wealth of advantages. Tax benefits, cash flow, and leverage among them.
Western nations are imposing sanctions on Moscow, sure to exacerbate materials shortages and other snags in globalized supply-chains. Add on: Mainland China is again locking down entire cities, including factories therein, trying to beat the COVID-19 virus, even as the more-infectious omicron variant spreads.
From academics to working financiers, it is understood that higher inflation eventually causes tighter central-bank monetary policies, and that often triggers a recession.
And inflation is with us. Scotiabank in mid-March issued the blunt report entitled, “Inflation Expectations Have Become Unanchored.”
Indeed. The US consumer price index (CPI) in February was up 7.9% on year and appears to be accelerating. In response, the US Federal Reserve Board is walking back its “inflation is transitory” outlook, and raising interest rates, and promises to do so for more than a few seasons.
No one takes comfort in higher inflation rates, let alone recession and war. But commercial real estate has endured through many business cycles, and through any number of geopolitical conflicts. If there are investor refuges to be found in the next several years, commercial property is surely high on the list.
The short story is that property values, and rents, tend to rise along with general inflation. The higher rents undergird property values.
In addition, general commercial property is regarded as a stable asset, certainly in comparison with enterprises now contending with vulnerable supply-lines or exposed to higher energy prices.
Interestingly enough, there are no general U.S. commercial property price indices that extend back into the 1970s. However, as a proxy, there are indices of residential property prices.
From 1970 to 1980, the U.S. consumer price index (CPI) rose 112.4%, as prices more than doubled during that decade. Serious inflation.
But the national median house price rose much more, by 177.8%, from the first quarter of 1970 to the fourth quarter of 1980, according to US Census Bureau and other federal price series.
And the 1970s rise in property values happened despite much higher interest rates than today, which, of course, affected the cost of carrying a mortgage.
Though it may be hard to fathom in the 2000s, in 1970 the average home mortgage rate in the US was about 8.0%, while in mid-1980 the average mortgage rate peaked at 16.3%. So, despite a doubling of mortgage rates in the 1970s, property values kept rising through the inflation-ridden decade.
Rising interest rates do hamper new development, as banks charge more for fresh mortgages. Fewer new projects “pencil out” under the burden of rising debt burdens.
In addition, the soaring bills for labor and materials used in construction also raise the economic threshold for new development.
All these conditions throttle new supply and tilt the tables in favor of existing commercial property landlords.
Unfortunately or otherwise, all of these supply constraints have been magnified in many US cities, due to extensive regulations, property zoning and other impediments to new development.
Whether natural or artificial, scarcity of available, rentable property in coming years will benefit the landlord.
Inflation and attendant higher interest rates reward some investors while hurting others, and in an inflationary period, it makes sense to join the side that gets rewarded. The blunt truth is that investors with debt loads see decreasing burdens in times of inflation.
This maxim, of course, applies to commercial real estate owners with fixed-rate mortgages, or other mortgages not fully adjustable to inflation.
As rents rise with inflation, commercial property owners obtain greater income but their monthly payments remain largely fixed. Again, no investor looks forward to higher inflation rates—but existing, leveraged property owners are poised to actually benefit from the process.
“Historical precedent suggests and Clarion Partners believes that private real estate can effectively hedge inflation. An analysis of the 43-year history of the NCREIF Property Index performance under different economic scenarios suggests that private real estate total returns were strong during the years of high/medium real GDP growth and high/medium inflation,” wrote Clarion Partners in late 2021, on behalf of partner Franklin Templeton, the money management giant.
Based on the track record, owners of commercial real estate can expect near double-digit or better returns in periods of moderate or high inflation, when combined with medium or high real economic expansion.
But even in periods of high inflation and low economic growth—the infamous “stagflation” scenario—commercial private property yielded a 3.9% return, in past periods.
While a sub-4% annual return in commercial real estate may not turn heads, it might be among the better returns available in pending years, if stagflation becomes the medium-term norm.
In the US, the logistics (industrial-warehouse), apartments and certain specialty sectors, such as cellphone towers, are poised to at least hold their own in coming seasons.
The industrial-warehouse market will continue to benefit in 2022 from the ongoing consumer switch to online ordering, and growing volumes as Western economies back order materials to fill gaps in the supply-chain. With Russia and China less dependable suppliers, yet more on-shoring to US supply chains may occur, increasing domestic demand for warehouse space also.
As widely noted, housing has become prohibitively expensive all along the West Coast and in several other markets, in large part due to intractable supply constraints. Housing and multifamily should have a solid 2022, particularly in certain Sunbelt markets that may benefit in migration inflows. While interest rates may creep up in 2022, the experience of the 1970s was that housing prices kept rising despite rate hikes.
The outlook for the nation’s office and retail markets in 2022 is mixed, with employees possibly returning to their old warrens post-pandemic, and social-distancing rules ending, thus boosting both markets. Recovery may be slow, but on the other hand the entry-point prices may be right.
There are no guarantees in investing, but in uncertain and inflationary times, real estate has proven it mettle repeatedly, through various business cycles and intimidating headlines. In 2022, property may again be the refuge that it has been so often before.
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Commercial Real Estate (CRE) investment provides savvy investors a wealth of advantages. Tax benefits, cash flow, and leverage among them.
A recent article from CNN, “The Office, As You Know It, Is Dead”, suggests that working from home may not be a short-term phenomenon, but instead a permanent shift to remote working even after a vaccine is found for Covid-19.
Real estate professionals tend to be old-school. A room full of investors, brokers, and mortgage lenders may resemble an episode of Mad Men more so than an episode of Silicon Valley, complete with the bourbon and the blue blazers. Real estate, they say, is a business of relationships—a series of handshakes, meetings, and phone calls, learning who can play ball and who can’t over luncheons, mixers, tee times, and kids’ graduation parties. That’s how deals get done.