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Deutsche AWM: CRE returns to decline in next five years

The alternative investment management arm of the German bank predicts that US property returns will moderate in the coming years, based on shifting drivers of those returns.

The past five years has been a period of robust performance for US commercial property market. Those outsized returns, however, are expected to normalize over the next five years, according to Deutsche Asset & Wealth Management.

In a report released this week, the alternative investment management arm of Deutsche Bank noted that the National Council of Real Estate Investment Fiduciaries Property Index (NPI), a benchmark of unlevered private commercial real estate, returned 13 percent year-over-year during the second quarter, trumping the returns on both large-cap stocks, which delivered 7.4 percent, and bonds, which generated 1.7 percent. Over the past 35 years, total returns for unlevered commercial property have averaged 8.8 percent annually, outperforming bonds but underperforming large-cap stocks.

However, Deutsche predicted commercial real estate returns would decline over the next five years to an average of 7.3 percent annually, and that the drivers of those returns would change significantly over that period.

From 1980 through 2009, income returns were the dominant driver for total returns for commercial real estate, while cap-rate compression gave an added boost through capital gains, according to the report. Over the past five years, income returns have moderated, but total returns continued to exceed 12 percent annually through a combination of further cap-rate compression and net operating income growth that pushed up capital gains to an average of more than 6 percent a year.

Looking forward, “the return outlook over the next five years will differ both in scale and composition,” Deutsche wrote in its report. “Income returns will be lower and cap rate expansion will drag on capital gains. However, robust fundamentals are expected to drive strong NOI growth, allowing for value growth averaging 1.8 percent annually.”

One risk factor to commercial real estate returns, however, is the possibility of rising interest rates. If rates rise dramatically, and is not matched with a commensurate improvement in the economy, cap rates could increase more sharply, which would dampen property values and returns, the report said. Yet as the capital markets heat up on the back of a rate hike, cap rates could potentially compress more than expected and drive growth in property values.

Although commercial real estate returns are expected to be lower than in the past, they still exceed the return forecasts for other asset classes on a risk-adjusted basis, Deutsche said: “Compared with those of the other major asset classes, commercial real estate returns are more stable than stocks, more volatile but less interest-rate-sensitive than bonds and less liquid than both.”