The commercial real estate investment cycle

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1 August 2013 The commercial real estate investment cycle Market indicators suggest upside potential Martha Peyton, Ph.D. Managing Director and Head of Real Estate Strategy and Research, TIAA-CREF Executive Summary Leading indicators support a positive investment outlook for commercial real estate as the cycle matures. Investor risk appetite for both commercial real estate and other asset types is strong, but with no clear evidence of bubble conditions. Above-average cap rate spread over Treasuries should help reduce the potential impact of rising interest rates on real estate values. Improving real estate fundamentals support the potential for attractive returns possibly into 2015, when rising rates and additional space are likely to reduce performance. W W Leading indicators support our view that core real estate offers better long-term growth prospects in the current environment than higher-risk strategies.

2 Commercial real estate cycle still maturing Historical patterns suggest the commercial real estate cycle is maturing, but has further upside potential. U.S. commercial real estate returns measured by the NCREIF National Property Index were nearing their previous peak in early 2013, with about 3% to go on a quarterly basis (Figure 1). Since 1978, real estate expansions have lasted an average of 31 quarters. Currently at 15 quarters, history suggests the expansion is roughly at its midpoint, with more room to run. Figure 1: Commercial real estate cycle has upside potential NCREIF NPI* quarterly total return and U.S. recessions 1978 to 2013 Q1 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% -10.0% Source: National Council of Real Estate Investment Fiduciaries (NCREIF), (1Q 2013) * It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs. 2

3 Leading indicators support further growth Index returns are backward-looking and don t provide enough information to judge the market s capacity for continuing growth. To gain insight into its potential direction, we monitor the underlying factors that drive commercial real estate performance. These forward-looking indicators include capital markets conditions, debt availability, real economic conditions and real estate fundamentals. Capital markets: Despite a one percentage point increase in the 10-year Treasury rate since May, interest rates remain at historic lows, supporting ongoing modest economic growth. Investor appetite for risk, which we monitor through high-yield corporate bond pricing, is solid on average with some sub-markets showing signs of bubbliness. Debt availability: Lack of construction financing is constraining new space development and supporting rental growth. Access to commercial mortgage financing is improving, helping to provide financing for real estate transactions. Real economic drivers: About 6.7 million of the 8.7 million jobs eliminated during the recession have been replaced, reducing the unemployment rate to 7.6% in June, from its high of 10% in While the pace of employment growth remains modest, it is strong enough to support further upside in commercial real estate investment performance (Figure 2). Figure 2: Job growth trend remains positive Total U.S. employment growth 3-month rolling average, year-over-year change 2% 1% 0% -1% -2% -3% -4% -5% -6% Source: Bureau of Labor Statistics/Economy.com (June 2013) Real estate fundamentals: Employment growth is pushing vacancy rates downward across all four property types. Limited supply has led to improvements in rent growth, with apartments leading the way. 3

4 Drawing implications for real estate pricing Close examination of commercial real estate pricing is warranted, given that prices on average have nearly fully recovered, with hints of bubbliness in some non-real estate asset types. Our indicators offer evidence that pricing is not excessive. In particular, commercial real estate debt flows are moderate with no signs of overheating. Further, total credit market borrowing is below the long-term average and far below pre-recession highs (Figure 3). In other words, debt markets are not turbo-charging risk appetite as they did in the years leading up to the 2008 collapse. Finally, capitalization rates are also important in assessing prospects for commercial real estate pricing. Cap rates defined as net operating income (NOI) divided by property value reflect the combination of macroeconomic conditions and market fundamentals. The transaction cap rate spread is materially wider than its historical average, adding further assurance that a real estate bubble is not underway. Figure 3: Below-average borrowing helps prevent bubble conditions Total credit market borrowing as % of GDP 40% 30% 1998 to 1Q13 avg growth 20% 10% 0% -10% Source: Federal Reserve, Flow of Funds (1Q 2013) 4

5 Extra cap-rate spread can help offset rising interest rates Another concern is the potential effect of rising interest rates on commercial real estate. Rising rates will be engineered by the Federal Reserve when economic growth strengthens enough to warrant tighter monetary policy. Stronger growth, in turn, will help to push property vacancy rates lower and propel rents and property cash flows higher. Stronger cash flows will help to offset some of the negative impact of higher interest rates on property values. Additionally, the average cap-rate spread on NCREIF property transactions versus 10-year Treasuries is more than 100 basis points above its long-term average (Figure 4). This wide gap is available to further cushion the negative impact of higher interest rates. Figure 4: Cap-rate spread over Treasury rate is wider than average Cap rates vs. 10-Yr Treasury rates 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Cap rates 10-yr Treasury rate 1Q 2013 actual Sources: NCREIF and Federal Reserve (1Q 2013) Fed interest-rate policy will be critical for market stability and growth The Federal Reserve s announcement that it plans to gradually normalize monetary policy has triggered significant volatility in financial markets. While rising rates generally reflect a strengthening economy, growth will suffer if the Fed tightens too much or too quickly. In addition to careful timing, the Fed needs to effectively manage market expectations to avoid excessive volatility. Despite concern about the potential for a hard landing, we are confident the Fed can manage risks related to policy timing and market expectations. 5

6 Positive outlook for real estate Our leading indicators support a favorable outlook for the U.S. commercial real estate market. We anticipate the NCREIF National Property Index will generate a 9% (plus or minus) return for 2013 consistent with its historical average, though below its 10.6% return in We expect the positive environment to continue into 2015, when the combination of rising interest rates and new construction is likely to constrain the market s performance. Monitoring forward-looking indicators will provide us with ample warning to adjust our investment strategy accordingly. Leading indicators support core investing Based on leading indicators, we continue to favor core real estate investments in highquality properties located in the largest and most liquid markets. The six largest metro-area markets have recovered 77% of their losses, versus 34% for other markets, and continue to offer opportunity at attractive pricing. Current market conditions discourage higher-risk investments in less liquid markets and properties requiring renovation. Slow improvement in vacancy rates and rent levels make higher-risk projects difficult to justify and construction financing is not readily available. Conclusion Low interest rates, an improving labor market, conservatively underwritten debt, and limited new space are helping to stimulate investor demand for commercial real estate. Core property is well positioned to generate attractive investment performance until Stronger economic growth and lower unemployment will ultimately trigger monetary tightening, with rising rates and additional space creating potential headwinds for investors. Careful analysis of the leading indicators that drive commercial real estate performance will help us meet the investment challenges ahead. C11982 This material is prepared by TIAA-CREF Asset Management and represents the views of Martha Peyton as of August These views may change in response to changing economic and market conditions. This material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Real estate portfolios are subject to certain risks, such as market and investment style risk, fluctuations in property values and higher expenses or lower income than expected, and potential environmental problems and liability. Past performance is not an indicator of futures results. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association (TIAA ). Teachers Advisors, Inc. is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA) Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY (08/13)

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