Nuveen TIAA

2012 Second Quarter Real Estate Markets Review: Steady Gains in the Face of Disappointing Economic Growth

Martha S. Peyton, Head of Global Real Estate Strategy & Research

Commercial real estate performance has reaped the benefits of this comparative economic steadiness, even in the face of lackluster growth. For the four-quarter period ended June 30, 2012, the NCREIF Property Index (NPI) posted a 12% total return vs. 13.4% for the prior four-quarter period. During the same period, income returns were steady at 5.9% vs. 6.0% previously, while capital returns tightened to 5.9% from 7.1% posted in the prior quarter.

Investor interest remained concentrated on the highest-quality properties, especially apartments, in major markets, including San Francisco, Boston and San Jose. The weakest performance occurred in metro areas that still face economic challenges, such as Pittsburgh, St. Louis and New Haven, CT. Additionally, commercial real estate has benefited from the sectors of the economy that are doing well, including technology, professional services and business services. The ongoing migration of tenants to higher-quality space is another positive trend.

These sources of return do not appear to be tapped out and can continue to bolster net operating income growth even if macroeconomic growth remains weak. However, there is evidence that stronger growth might be forthcoming, and that evidence supports economic forecasts showing a return to 3% growth by the end of next year. An important driver behind that forecast is the continuing slow healing in the housing sector along with an eventual bottoming-out in state and local government cutbacks. Even if these forecasts prove to be disappointing again, property values can hold steady because disappointing growth will keep Treasury rates very low.

Retail property takes first position

In the second quarter, retail property—the only property type to see returns increase—leapfrogged into first place among the major property types from third place previously. Total returns averaged 13.4% for the four-quarter period that ended June 30, vs. 12.9% for the four-quarter period that ended March 31. Income returns were largely unchanged at 6.4% vs. 6.5% in the previous period, while capital appreciation returns increased to 6.7% vs. 6.1%. Availability rates in neighborhood and community centers inched down to 13% vs. 13.1% previously; however, retailers remained cautious about opening new stores given the uncertain economic outlook. Still, there are signs of improvement, with national inline tenants reporting solid same-store sales growth and strip center REITs reporting stronger-than-expected leasing activity and modest rent growth.

Apartment properties cede pole position

Apartment properties recorded the second-highest total return among the major property types at 13.2% for the four-quarter period that ended June 30, although they slipped from 14.8% for the four-quarter period that ended March 31. Income returns held steady at 5.4%, the same as in the prior quarter. Although capitalization rates (cap rates) edged down slightly to 5.42% for the period vs. 5.44% in the prior period, capital appreciation in the apartment sector was still the highest among the major property types in the second quarter Construction is picking up, with a still-modest 125,000 units expected in 2012, but the pipeline for 2013 and 2014 is growing quickly. The obsolescence of older units and favorable demographic trends will bolster demand for this new inventory.

Industrial sector moves to third place

Industrial property slipped from second to third place among the major property sectors, with total returns of 12.2% for the four-quarter period that ended June 30 vs. 13.9% for the four-quarter period that ended March 31. During the same period, income return fell slightly, from 6.5% to 6.4%, and the capital appreciation return decreased to 5.6% from 7.1%. Fundamentals continued their gradual improvement, supported by GDP growth, a 1.5% increase in industrial production in the second quarter, and still-healthy global trade flows. Cap rates remained virtually unchanged, while net operating income grew modestly for the quarter at 2.5% vs. 2.3% previously. Though vacancy rates remain elevated, new construction remained minimal.

Office sector lags in last place

For the second consecutive quarter, office properties were last among the major property sectors with a 10.5% total return for the four-quarter period that ended June 30 vs. 12.8% for the four-quarter period that ended March 31. Income returns were largely steady at 5.8% vs. 5.9% during the prior quarter. Property values increased, but capital appreciation slowed to 4.6% from 6.6% previously. On a brighter note, the national office vacancy rate fell to 15.7% in the second quarter vs. 16.0% in the first. As with the industrial sector, office rents remain well below the levels needed to justify new construction. In the interim, the lack of large blocks of contiguous space in major markets and the technological obsolescence of older buildings will be the primary factors driving new construction.

The road ahead

In our view, the foundation for solid performance in the commercial real estate sector remains in place over the near term due to a still-improving labor market, ongoing minimal construction, and continued investor interest in the sector. In addition, we believe that the environment for commercial property will be further enhanced over the medium term, as the Fed is likely to keep interest rates low through late 2014 due to the subdued outlook for inflation.

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