Many Happy Returns: Investors Are Flocking to Real Estate, But Will It Lead to a Bubble?

PLAY OF THE LAND

If you had a dollar and an eye toward the future, which of these assets would you invest in: bonds, equities or real estate?

According to data from the National Council of Real Estate Investment Fiduciaries (NCREIF), you may want to put your dollar in real estate.

The NCREIF Property Index (NPI), which tracks 6,971 investment-grade, income‐producing properties in the U.S., posted an average 8.16 percent return over a 10-year period, compared to 3.99 percent posted by the Barclays Capital Government Bond Index and 7.89 percent posted by the Standard & Poor Index in that same timespan.

This strong performance is a good indication that property is a “safe haven for investors in troubled times,” says Richard Barkham, global chief economist for CBRE.

Investor confidence has been buoyed by the relative economic strength of real estate markets in key gateway cities in the U.S.—including New York City, Boston and Chicago, among others—and the lack of development activity, making real estate investment an attractive alternative to other asset classes.

“People have slightly lost faith in equities, which used to be a bulk of institutional portfolios,” Barkham adds. “There was quite a lot of concern about inflation after the recession, and property gives you a good income return and potentially some protection against inflation.”

Volatility

As opposed to stocks and bonds, which are traded on a daily basis and go by the conventional wisdom that the higher the volatility, the bigger the rewards (or losses), real estate offers investors a comparatively safer opportunity.

There is a solid income stream from real estate investments, and you do get movements over time in value, but it shouldn’t be as volatile as the equity market.

“Equities seem to have become more highly correlated with consumption than they used to be, so are less of a hedge against bad times. This has marginally increased the preference for real estate,” says Barkham.

Building values tend to change in relatively calmer fashion than stocks, says Jeffrey Havsy, chief economist in the Americas for CBRE.

“There is a solid income stream from real estate investments, and you do get movements over time in value, but it shouldn’t be as volatile as the equity market,” adds Havsy.

The investors themselves hail from far and wide: domestic investors, foreign investors, sovereign wealth funds, foreign pension funds, high net worth individuals and REITs, each with varying needs and wants. Globalization has made many countries wealthy, and investors and institutions from the emerging markets are strongly attracted to real estate.

“The types of investors haven’t been changing,” says Havsy. “It’s the number in each category that’s been changing over time.”

Low Interest Rates

Low interest rates have also contributed to the strong performance of real estate as an asset class, which, according to Barkham, takes the stresses off the underlying tenants while reducing the cost of capital.

Deal activity has been escalating in both in the U.S. and Europe. Commercial real estate transactions in the U.S. in the first half of 2015 were valued at US$225.1 billion, according to Real Capital Analytics, a 36 percent increase from the year before, reports The Wall Street Journal. Transaction values in Europe were US$148 billion, the highest since 2007.

In New York, the commercial real estate market has an average capitalization rate of 5.7 percent (as opposed to a 2.2 percent yield on a 10-year treasury note), Real Capital Analytics told The Wall Street Journal.

“For the next two to three years, we should see this strong growth continue to push up rents, which gives investors good property returns,” says Barkham.

In the Midst of a Bubble?

All this activity is causing some experts to fear a commercial real estate market bubble.

There’s no reason why property shouldn’t generate a good risk-adjusted return in the long term. But there is always a cycle.

“I think that by late 2018 there will be another property recession,” says Barkham. “If interest rates go up, it will eventually put a break on rental growth and push cap rates as well,” he adds.

While an increase in interest rates will impact investors, the increase won’t be too drastic, argues Havsy.

“The amount of capital out there will remain strong, and that’s going to be a challenge for investors as they compete for access,” says Havsy.

This will push investors to look further afield for opportunities, which may send them to new markets that were previously unexplored.

“In a world where there’s huge population growth and a reasonable level of economic growth with inflation, there’s no reason why property shouldn’t generate a good risk-adjusted return in the long term,” says Barkham. “But there is always a cycle.”

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