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Why Investors Are Bullish on Commercial Real Estate

Optimism is back for commercial real estate. Property performance through the third quarter of 2021 reflects considerable gains for real estate investors, while interest rates and inflation are of limited concern to the asset class.

Investment returns for institutional-quality properties hit a 15-year high in the third quarter of 2021, according to the National Council for Real Estate Investment Fiduciaries (NCREIF). NCREIF tracks institutional-quality commercial property and fund performance, using data provided by its investment-management members.

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The NCREIF Property Index (NPI) total return for Q3 2021 was 5.2%, comprising a 1% income return and a 4.2% capital return (or appreciation). The last time the NPI quarterly total return was over 5% was Q4 2005. For context, the 20-year average quarterly total return is 2%.

Q3 2021 commercial property performance was stunning. But it is also impressive given the very short and shallow depreciation cycle in 2020. Depreciation, as measured by the capital return, lasted only two quarters (Q1 and Q2 2020) and resulted in cumulative depreciation of only 2.7%. As a result, commercial property values in the NPI are already 5% above their pre-pandemic peak.

Rents were under pressure early in the COVID-19 pandemic when tenants were returning space to the market for sublease or delaying new leases. In 2021, the economy is roaring back. Economic growth is proceeding at its strongest annualized pace in 15 years, too. Plus, as of November 2021, 18.5 million jobs have been recovered out of the 22.4 million lost during the pandemic.

What about interest rates?

In 2022, interest rates will likely edge up as the Federal Reserve completes its tapering of asset purchases. It is possible that the federal funds rate could be raised in 2022, but this would be a data-driven decision based upon continued strong growth in the economy.

More growth is good for real estate, but higher interest rates can impact values through capitalization (cap) rates. Cap rates measure property income as a share of market value. For NPI properties, cap rates on current valuations have averaged a historically low 4% from second quarter 2020 through third quarter 2021.

Although the cap rate is low, the cap rate spread -- the difference between two cap rates and 10-year U.S. Treasury yields -- is wider than its long-term average. The 20-year historical average cap rate spread is 250 basis points (bps), compared to 266 bps in Q3 2021 and a trailing year average of 275 bps. In other words, cap rate spreads are generally rising. A wider spread indicates that commercial property can offer better yields and makes it possible that the spread could compress, as opposed to cap rates rising, in response to higher interest rates.

What about inflation?

Inflation is the reason interest rates are expected to rise, but it is also a driver for capital flows into real estate. Commercial property is considered a hedge against inflation because rents paid to owners tend to rise with general price levels, supporting returns during inflationary periods. For non-income-producing assets, inflation can serve as a drag on performance.

Economic growth thus far has driven this commercial property performance, and the recovery isn't even over yet. At this point in the real estate cycle, there are opportunities to capitalize on rising rents, rising demand for space, or -- depending on the specific property -- both.

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