The question today is whether outsized returns in US real estate should be expected to continue. The PREA-IPD US Property Fund Index shows US real estate had an annual unlevered return of over 12 percent for the past five calendar years. Last year's return was 11.5 percent, so there to date has been little let up as the good times have continued to roll.
The greatest risks may lie in core in the primary markets where the gains have been the greatest. For instance, central business district (CBD) offices in New York-Northern New Jersey have returned an average 14 percent over the last five years, while CBD office in San Francisco has returned an even more impressive 18 percent per year.
Above average returns have been driven largely by cap rate compression, with the most dramatic compression in the primary markets. Data from Real Capital Analytics (RCA) shows Manhattan office cap rates have dropped 170 basis points since 2010 and now average 4.5 percent. San Francisco office cap rates, meanwhile, fell 190 basis points from 2010 to 2014. Similar stories have played out for core properties in other major US markets too. Thus far, there is little sign of this abating; San Francisco office cap rates fell another 20 basis points in the first quarter of 2015 to 4.9 percent, according to RCA, for example.
With lower cap rates, what continues to attract capital to real estate is a low interest rate environment. Relatively speaking, the yields on real estate, even if lower than the historical average, can look compelling when the 10-Year Treasury is yielding less than 2 percent. However, this raises the fear that should interest rates rise, cap rates could reverse course, cutting returns going forward. I would suggest three reasons why rising interest rates are not likely to be a major risk factor over at least the next couple of years.
First, all of the media attention focusing on if and when the Fed might raise interest rates is essentially irrelevant. According to a recent report from PREA, there is virtually no evidence that the Fed has any influence over the long-term interest rates that are relevant to real estate values. Second, even if interest rates do rise, it is likely to be for the best of reasons: an improving economy. Historically, real estate has actually done better in rising interest rate environments because rising rates tend to coincide with improving fundamentals. Third, on a global basis, interest rates are not rising, but decreasing. Central banks in almost every major country outside the US are decreasing rates. As non-US investors search for a return and are faced with lower bond yields, real estate, including US real estate, may become even more attractive.
Further, non-US investors continue to strongly prefer the primary markets for their US real estate investments. Given continued capital flows into primary markets, there would seem to be little pressure for cap rates in major markets to rise significantly over the next couple of years.
However, while there are currently no signs of a major correction coming in US real estate in the near term, return expectations in the major markets should be tempered; the excellent returns of the last few years will likely not repeat themselves going forward. While cap rates may not rise, there is not that much farther they could fall; future appreciation will need to largely depend on net operating income growth, which, given current economic conditions, seems most likely to be steady, but unspectacular.
For many non-US investors, reduced return expectations may be just fine; the benefits of diversifying into US real estate can continue to make the asset class attractive to many investors even at reduced returns. Some US investors, however, may find themselves priced out of core in the major markets; we have already seen an increased interest in value-add strategies as well as secondary markets among US-based investors.
A gradual slowdown in returns from the US real estate market, but not a reversal, seems most likely. The PREA Consensus Forecast indicates that the market expects a 9.8 percent unlevered return to US real estate for 2015, with expectations falling to 8.4 percent for 2016, and 7.7 percent for 2017. Despite the downward return forecast, these numbers are still attractive in what remains a low interest rate world. Will the good times continue to roll for US real estate? The ball is still rolling, but it is starting to slow down.