While some property valuations appear rich and the market feels highly competitive, we are optimistic about the commercial real estate investment market in 2018. The keys to this optimistic sentiment are the recent comprehensive tax reform, a continuation of rising property values and, lastly, a growing economy.
Tax reform is a significant net positive event for real estate and we are bullish it will bring broad-based benefits across most sectors. Tax reform will release not only corporations to grow and build manufacturing in the U.S., but it also releases pent up consumer demand – both leading to higher growth in the U.S. economy. Faster economic growth will spur demand from users resulting in greater space absorption as well, something that has been lacking in the office sector for the prior two years.
For high net worth private investors, the tax reform bill provides substantial new benefits resulting in higher overall after-tax returns. The 20% deduction for qualified income from pass-through entities such as partnerships or LLCs and the expansion of depreciation rules are significant wins for investors. The pass-through benefit alone lowers a high net worth investor’s effective tax rate to 29.6% on qualified income.
Pricing & Cap Rates
Prices are still rising albeit now at a more sustainable, steady pace – note that prices grew by 7% in 2017 versus 17% in 2011. There are definite sweet spots in the market for investors seeking safety as well as growth (Industrial/e-commerce, Healthcare & Senior Housing), and those seeking opportunities to capitalize on pricing inefficiencies in the market (Multi-Tenant Industrial). In these areas, we see the bid-ask gaps decreasing and transactions are getting accomplished.
Crowded market conditions are favorable for sellers. Cap rates across the board remain below their long-term averages, as capital continues to flow into real estate. According to NCREIF, the latest 20-year average cap rate was 6.3%, as compared to the year-end 2017 average cap rate of 4.5%. As an illustration, for a typical Midwestern suburban office asset, current cap rates of 7%-8% fall well below the historical norms of 9-10%.
Inflation and Interest Rates
GDP is expected to grow by 3%-4% this year and we expect that to trickle down to real estate growth. Although interest rates are ticking upward, we are still in a low interest rate climate. The 10-year Treasury remains significantly below its historical pre-recession average range of 4% to 6%.
A rising interest rate environment is not something to fear. It signals a rising economy, which leads to rent increases and increases in value which typically outweigh increased financing costs. We are seeing increased sale prices for suburban office throughout the Midwest, partially due to the recent rise in construction costs, which in turn result in higher rents for new construction projects. Price increases trickle down to existing Class A assets in terms of rent growth, leading to higher NOI and higher values.