Accepting Success

After years of strong returns, can commercial real estate
investors be satisfied with merely positive results?

October 2018

By Bob Dougherty, Partner

• Values are peaking and returns are moderating
• Rising borrowing costs are placing pressure on cap rates
• Price declines seem inevitable but the trough is unlikely to be deep
• Too much capital is earmarked for real estate and unable to generate favorable returns elsewhere
• A return to historical cap rates is unlikely and commercial real estate remains rationally priced
• Tax code changes offer tremendous advantages to commercial real estate with impact in early stage
• Despite ever-improving market efficiencies, pockets of opportunity always exist
• Commercial properties are a proven long-term return generator with unique leverage and tax advantages

Last month marked the 10th anniversary of the bankruptcy of Lehman Brothers, the touchstone event of the 2008-2010 Global Financial Crisis. Memories of this monumental fall are so indelible that it is difficult to conceive of it as a decade old.  Indeed, many investors are still guided daily by lessons learned from that painful episode. These remembrances accompany them like a shadow of warning or, at the least ominous, a cautious friend. Ten years have passed but the spector of the GFC still haunts almost as if it were yesterday.

With this cloud above us, it remains difficult to accept relative prosperity and to grow comfortable with indications of success.  The current climate in commercial real estate exhibits many favorable dynamics and solid fundamentals, yet many investors continue to wait for the other shoe to drop… for 2+ years now. Real estate has been a cyclical industry for much longer than the past decade, so waiting for the turn from peak to trough makes sense even without “Depression Era” memories. However, as explored below (and with the usual caveat against exogenous events such as war, natural disasters, etc.), there are scan indications that a precipitous decline is in the offing. Instead, we believe there are many signs pointing towards a slow and modest correction in property values/returns and equal likelihood that the surprises could be to the upside in some cases, not even the proverbial “soft landing” scenario.

This relative comfort level with the current investment environment is based upon (i) a fairly robust economy, (ii) property cap rates in comparative conformity with investment alternatives, (iii) abundant capital designated for commercial real estate and in search of yield, and (iv) favorable supply and demand fundamentals. Additionally, recent tax code changes have sweetened the incentives for investments in commercial real estate and have also led to billions (perhaps trillions) of dollars being repatriated to the U.S. This incoming capital will compete for assets, including real estate, and may have a suppressive effect on interest rate increases. This could lead to domestic investment which generates even more job growth – part of the potential upside surprise referenced above. Lastly, a couple separate but related phenomena are likely to lessen the amplitude of not only this but future property cycles: (a) banking and financial markets regulations and (b) ever-improving capital markets efficiencies.

The overall U.S. commercial real estate market is in a period of adjustment as investors grapple with rising interest rates, slowing income growth, and exigent economic forces (with global trade tensions presently at the forefront). Purchasers of properties must incorporate higher borrowing costs and slower rental growth into their underwriting. Thus, at current prices, investors are unable to replicate recent yields. Accepting last year’s cap rate produces diminished equity returns at the very time when more yield should be required to reflect lower NOi growth and growing risk. Accordingly, like most purchasers, Buchanan is beginning to demand lower property prices.

However, sellers looking in the rearview mirror at recent trades are understandably reticent to adjust expectations. The bid-ask spread resulting from this stalemate has depressed overall transaction volume, and nationwide sales were off nearly 20% in the first half 2018 compared to the same year-ago period.

Source: Costar Portfolio Strategy

Our own experience is reflective of these national trends, but the overall volume figures tend to be driven substantially by higher-valued assets in gateway cities. In Buchanan’s “middle market” space (properties valued at $25-$75 million), while most bidders have lowered offers, an outlier buyer often appears above the field. (This tends to happen less frequently in the >$100MM institutional property space.) Sometimes these breakaway bidders simply have a more optimistic underwriting outlook but often they are motivated by different factors. Gain-sheltering in tax-deferred 1031 exchanges or capital preservation – common with foreign buyers bringing money to the U.S. – allow some investors to accept lower yields. For now, these buyers are closing and keeping sellers emboldened, but just as the peloton almost inevitably reels in the breakaway rider, these outliers cannot sustain the market and prices will eventually decline as cap rates expand. Buchanan’s investment underwriting is presently being guided by this view, and the chart below shows how this broader market outlook is leading to flattening property pricing nationwide:

The logical follow-on question is “Are we seeing the end of the run, the peak before a protracted price slide7” Our view is that prices will correct and cap rates will edge up but not dramatically. How soon and precipitously this takes place is difficult to predict and is likely to be influenced by macro-economic forces such as employment and GDP growth and the Federal Reserve’s monetary policies to a greater degree than real estate fundamentals and capital flows. Real estate dynamics seem reasonably predictable right now. Supply and demand are in relative balance for most property types in most markets (despite limited pockets of over-building). Most markets are experiencing solid occupancy and continuing, albeit moderating, rental growth.
In actuality, favorable conditions for rental growth exist for many property types in multiple markets, particularly some of Buchanan’s target markets in the Western U.S. which are exhibiting some of the nation’s fastest-growing population, employment, and GMP growth. However, with rental growth having tapered off broadly, most investors are underwriting an extrapolation of this slowing trend and are unwilling to interpret these economic metrics as signals for accelerating income growth. Instead, buyers are looking at any such favorable surprise as their icing on the cake.

Source: CBRE-EA, Clarion Partners Investment Research, Q2 2018

Strong job growth and near record-low unemployment is bolstering demand for properties. At the same time, development has not run amok in this cycle, thanks to still fresh memories of the crash and to financial regulations functioning as designed to curtail over-borrowing. Additions to inventory on a percentage basis have been lower than construction in previous post-recession cycles. Additionally, most of the data indicate that development in this cycle has peaked and will taper off after 2018 (see chart above), particularly given that construction costs have been rising much more rapidly than general inflation. Consequently, investors are not overly concerned about property market fundamentals but are waiting for the yield premium that compensates for higher interest rates and slower income growth.
When this comes, there are indications that capital will flow, not trickle, back into the market – placing a bottom on any price declines. Dry powder raised by private equity real estate funds remains at an all-time high (see chart below), and many U.S. institutions’ real estate holdings persist below their target a I locations. Foreign direct investment, despite having tapered off in 2016-2017 (just as domestic capital flows did), remains elevated in comparison to historical levels and has rebounded significantly in the first half of 2018.

Source: Preqin

All of this is part of a long-term global trend in favor of “alternatives;’ as investors worldwide seek yield and find increased comfort in alternative investments based upon rapid improvements in the transpa­rency, efficiency and liquidity of these non-public markets. For many, real estate is at the forefront of these allocations, the “least alternative” alt. This macro phenomenon is also likely to prevent cap rates from returning to historical averages and will ensure that they stay relatively low and that property prices remain comparatively elevated for some time to come.

Source: NCREIF


As the chart above illustrates, The long term trend in property cap rates is decidedly downward even taking into account spikes spikes resulting from the early ’90’s savings and loan crisis, the 2000-2001 dot com bust, and the 2008-2009 global financial crisis. However, despite historically low cap rates, U.S. real property has appeared rationally priced during the market’s bull run. When viewed in comparison to other investments, com­pressed cap rates are symptomatic of the low-yield environment that has prevailed across a broad range of asset classes.

The chart below presents a history of the spread between NCREIF’s National Property Index (NPI) cap rate and (a) the 10-year U.S. Treasury bond and (b) BBB­ rated corporate bonds. As illustrated, the risk premiums for investment in the institutional-quality properties which make up the N Pl has hovered relatively close to its 20-year historical average since the middle of 2015. The market has not witnessed the spread compression in commerciaI real estate that preceded the 2001-2002 recession or the dramatic drop in 2004-2008 leading up to the global financial crisis. Instead, the cap rate spread fluctuated around 1% vs. BBB corporates and around 2.75% vs. the 10-year UST from 2015-2017.


Source: NCREIF

However, the yield on the Treasury bond has increased by over 75 bps since 4Q17 and the BBB corporate bond yield has risen by approximately 100 bps over the same period. Meanwhile, property cap rates (which typically lag in reporting) have remained flat compressed in 2018, so there’s evidence which has yet to appear in the data that the real estate risk premium is now meaningfully below its 20-year historical average and this is reason for investment caution unless and until cap rates edge up as we expect.

With the following characterizing the current investment climate …

• Low Cap rates; high property values
• Moderating income growth
• Solid but slowing fundamentals
• Pressure on equity returns from rising interest rates
• Ever-increasing market efficiency

… where can the discerning investor find an edge and what will cause property investments made today to succeed over the long run.

Finding special situations during market dislocation

There are few signs of a major disruptive event looming on the horizon. Of course, in today’s turbulent socio­political climate it is very difficult to confidently dismiss this possibility. Nonetheless, investors who played their hands in fear of the wildcard over the last couple years have missed out on significant gains which were clearly signaled and underpinned by robust economic funda­mentals. Charting the more predictable course moving forward, investors should expect property yields to remain low, but they should be rewarded over the long run by exploiting a near-term market correction and seeking mispriced investments. While real estate markets exhibit ever-increasing efficiency, special situations always exist and are more prevalent in smaller properties. The investor who can identify these opportunities will benefit from uncovering pricing dislocation.

Secondary markets poised to shine

Painting a market as large as U.S. commercial real estate with one broad brush – as many of the charts cited above do – glosses over opportunities revealed by examining its finer points. One such area of nuance is the spread between primary and secondary markets. As noted above, the market-wide indices tend to be disproportionately influenced by high-value properties found in major markets (defined by leading research firm, Real Capital Analytics, as Boston, New York, Washington, Chicago, Los Angeles, and San Francisco). With most institutional capital placing a premium on safety emerging from the recession in 2011-2012, trophy properties in gateway cities were bid up.

These investments were rewarded handsomely, as core real estate outperformed many asset classes in investors’ portfolios from 2009 through 2015-2016. But doubling down on this trend later in the recovery has driven yields for core real estate to an untenable level for many investors, particularly when taking into account the rising risks posed by stratospheric rents and competition from new development which has been highly concentrated in gateway markets. Conversely, many secondary markets offer strong population and employment growth fueled by companies and employees seeking lower costs, and these smaller cities don’t face the same supply threats as their gateway counterparts. In these non-major markets development remains uneconomic because rents haven’t hit “replacement rents” necessary to justify wholesale building.
The spread between the major and non-major market cap rates has widened significantly given the yield compression in primary markets. Investors, both foreign and domestic, have taken note and have begun to focus on the value proposition in secondary markets. This influx of capital has the potential to narrow the secondary market premium and to augment value and liquidity for these investments.

Source: Real Capital Analytics as of September 2017

When profits are scarce, seek long-term income

Lastly, it is worth remembering that commercial real estate is generally a positive return generator when viewed over the long run. The average annual total return (income plus appreciation) from the core-leaning NCREI F N Pl (approximately 7,500 properties and $570 billion of market value in 2018) has been 9.5% unleveraged over the 28-year period 1979-2017. Over the past 5 years, through 1Q18, the index properties generated a 10.1% annualized return and, even taking into account devastating performance in 2009-2010, the N Pl produced a 6.3% unleveraged return over the past 10 years through 2Q18.

Source: NCREIF

When the typically favorable impacts of prudent leverage and the positive tax attributes of commercial real estate compared with other asset classes are taken into account, the return metrics become even more compelling.


It is difficult for investors and market analysts to view markets, particularly commercial real estate, as something other than highly cyclical. This is especially true when just in the last 30 years three dramatic boom cycles – the late – 80’s fueled by tax reform, the dot com explosion of the late-90’s, and the credit fueled binge of 2003-2008 – have taken place.  These represented impressive peaks followed correspondingly depressing falls – the early 90’s “S&L Crisis”, the bursting of the “Dot Com Bubble”, and the “Great Recession”, respectively.  The default thinking says that when the property market peaks, it must fall until it hits a dark bottom and then rebuild from there.  For market participants who 10 years ago experienced the harrowing depths reflected in the chart above, their outlook remains colored by this trauma which still guides their actions.  However, is it possible to have a nameless correction?  One that is more dip than cliff or even slide?  The factors discussed above suggest that, despite justifiable fear, this is precisely what is happening. The soft landing may be underway and it might even be a fly-by.


The TCW Group, Inc owns 32% of Buchanan Street Partners

This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on source believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results.

Bob Dougherty is a Buchanan partner and institutional portfolio manager. He sits on the investment committee and is approaching his 15-year anniversary with the firm.