Interest rates remain low and commercial real estate (CRE) spreads near historic highs. Large cushion for CRE to handle interest rate increases. Read the key questions and findings below for a look at what is to come. Request the full 2022 Outlook.
Will inflationary pressures be transitory or persistent and how might it impact property valuation?
The U.S. economy and to a lesser extent the rest of the developed world are experiencing broad-based inflation due to a confluence of demand and supply oriented factors. Inflation is likely to remain above central bank targets for the next 1-2 years, but a secular shift to a higher inflation regime is unlikely. The Federal Reserve, however, has become more hawkish on the margin and this will contribute to higher interest rates sooner than recently thought – though rates will remain low by any historical standard. Contrary to popular belief, changes in interest rates and changes in cap rates have an extremely weak if any relationship historically. Rather, what matters is whether the economy is growing and whether cap rate spreads are wider or narrower relatively to history. The economy will continue to grow and spreads are mostly at around long-term average levels, which means that there is considerable scope for the market to absorb rate increases. Moreover, in the event that the economy were to move into a higher inflation regime, history suggests that commercial real estate returns would more than compensate for this higher inflation in the form of higher total returns.
Weak Correlation Between Fed Funds Rate & Cap Rates
What is driving the CRE market?
There is a capital tsunami coursing through the market and effecting all in its pass: debt, equity, volumes, valuations, asset mix, geography, you name it. The global money supply is 24% higher than it was at the end of 2019—that’s an increase of $20 trillion. A portion of that has gone directly into property market while still more is set to come as institutional investors rebalance their portfolios following huge run-ups in the values of their public equity portfolios. We are already seeing this in dry powder levels at close-end funds, which has risen 20% since December 2019 spread across all strategies. Open-ended core fund contributions are now increasing as is funding for public and especially non-traded REITs. Institutional investors are if anything becoming more bullish on real estate as they continue to increase the share of their growing portfolio allocated to the asset class, promising a long tailwind to the sector.
Dry Powder has Risen 20% Since Pre-COVID
How attractive is CRE pricing relative to its own history and alternative investments?
Commercial real estate returns have been well-above their historical average in the last year, driving valuations in many markets and sectors to record levels. This can be a cause for concern, but it is important to keep in mind that CRE is only one asset class among many for investors; hence, it is important to look at the valuations of CRE relative to these alternative investments, namely global public equity and fixed income. We find that CRE valuations represent a relative value compared to these alternatives, particularly fixed income; moreover, CRE offers higher yield per unit risk compared to other asset classes in addition to being a strong inflation hedge (see previous). All of these factors argue in favor of continued capital flows into CRE and sustainability of prevailing pricing.
Attractive Relative to Corporate Bonds
Cap rate vs. corporate bond spread
Where is the office market going?
The future of office continues to be the number one question for real estate investors. Our research shows that physical office occupancy continues to recover gradually across a broad range of markets, though there is considerable variance in absolute levels with gateway office markets continuing to lag compared to sunbelt and Midwest markets. Our base case remains that by mid-2022, this will have improved considerably, notwithstanding current concern regarding the omicron variant. Thinking longer term, we see remote and hybrid work strategies representing a persistent drag on office demand but one that is overcome by continued strong office-using employment growth. This augurs in favor of fast-growing secondary markets, mostly in the sunbelt and mountain west. At the same time, we have already seen a significant bifurcation in the office sector between newer, greener, better-amenitized office buildings and the rest. This was already a trend before the pandemic, but it has accelerated and we believe is liable to persist. This greater quality gap should be a critical component of any office investment strategy in the coming years.
Nevertheless, Office Will Fully Recover
Regardless of WFH dynamic, buildings will re-populate
What sectors and markets are driving transaction activity?
Transaction activity through the third quarter was on track for a record year, led by extremely strong activity in the multifamily and industrial product sectors – both up over 70% compared to the pre-pandemic average. Office and retail volumes are nearly recovered. Select niche investment sectors have also been winners in the pandemic market, notably R&D / life sciences, affordable housing and senior housing. Medical office has also been seeing an acceleration in investment. The rebound in activity is geographically broad-based—21 out the top 25 markets are on track to set new records in 2021. The gateway markets have been slower to recover, but the bear story on these markets is overstated: migration out of these markets was palpable but far from transformational and the same can be said for the relative decrease in leasing and investment sales velocity in the gateway markets.
Liquidity Rising Across Product Types
Led by apartment and industrial, though office volumes exploded in December
As borders open, how will cross-border capital flows impact the property markets?
Private and domestic institutional capital have driven the rebound in CRE capital markets thus far – both having acquired 40-50% more property versus the pre-pandemic average. REIT and cross-border acquisitions are also above pre-pandemic levels following an acceleration of activity in the fourth quarter. As borders re-open and the U.S. continues to lead the developed world in growth while hedging costs remain attractive, we expect to see this momentum in cross-border capital flows continue. Foreign investment is likely to be more focused on multifamily and industrial than prior to the pandemic but with office still representing a significant share. Inflows have already accelerated from southeast Asia and the middle east, and we expect this strength to persist in 2022 and to be joined by greater inflows from Europe. The addition of these investors to the market should help drive transaction activity to in 2022 and should help sustain pricing, particularly for already highly competitive sectors.
Pandemic Accelerated Shift to Industrial & Apartment
United States: share of cross-border acquisitions by product type