US commercial real estate (CRE) investment performance continued to soar in the first quarter of 2022 with wide disparities between property types. The National Council of Real Estate Fiduciaries (NCREIF) Property Index delivered an incredible total return of 21.9% for the four quarters ending in March 2022. Income return amounted to 4.2% and capital appreciation amounted to 17.2%, both for the four-quarter period. The industrial sector produced a total return of 51.9% in the same period, followed by the apartment sector producing a 24.1% total return. In comparison, retail and office produced a 7.1% and 6.8% total return, respectively.1 Fundamentals for CRE are increasingly uncertain as economic data published for the first quarter show signs of a slowing economy, with advanced estimates of first quarter real GDP growth slipping to negative 1.4%.2 Determined to get the continuing problem of inflation under control, the US Federal Reserve (Fed) increased interest rates by 25 bps in March, 50 bps in May, and expects to continue raising rates in 2022. The economic future continues to be clouded by Covid-19 and the war in Ukraine has added to disruption and uncertainty.
NCREIF Property Index
year-over-year change (1990 – 1Q 2022)
Source: NCREIF Property Index Detail Report as of March 31, 2022. Shaded areas indicate US recessions. Past performance is not indicative of future returns.
Cyclical, structural and geopolitical challenges in play for US CRE
First quarter US CRE investment performance reported by NCREIF’s National Property Index (NPI) offers a continuation of the extraordinary total returns produced during 2021. Total return for the year ending March 2022 reached a whopping 21.9% besting the 17.7% reported for 2021. Industrial continued to lead with 51.9% total return followed by apartments with 24.1%. Retail clocked in far behind at 7.1% with office even weaker at 6.8%. NPI income return held steady at 4.2% for the period while appreciation registered 17.2%.1 These results illustrate a continuation of forces underway in the later part of 2021 including recovery from the Covid recession helped along by the federal support policies enacted earlier in 2021. Additional performance drivers include sustained spending online with speedy delivery stimulating demand for industrial space and constraining demand for retail shop space, and ongoing disruption in office space occupancy and absorption reflecting work-from-home uncertainties. Even though these stunning results are welcomed, investors are eyeing the challenges ahead.
The most immediate challenge is the shift toward tightening in US monetary policy in response to the sharp rise in inflation. In its first post-Covid tightening move, the Fed imposed a 0.25% rate boost in March with a meatier 0.5% increase in May, and even more expected later in the year. Separately, the Bank of England has tightened three times since December while the European Central Bank is discussing the possibility of rate hikes for later this year. In this environment, the US yield curve has flattened, and the 10-year Treasury rate briefly surpassed 3% but backed down suggesting that financial markets have confidence in Fed policy.3 Commercial mortgage lenders are absorbing some of the rate increase by squeezing spreads but borrowing costs are increasing albeit with ready availability. The increase will make it tougher for investors to hit performance targets if historically low borrowing costs had been assumed to continue indefinitely.
The larger challenge involves the possibility that monetary authorities will fail to engineer a “soft landing” and cause a recession by tightening too much. The potential for overshooting is not immaterial because of the complex forces driving inflation and the crudeness of interest rate tightening as a policy tool. Higher interest rates operate largely by constraining interest sensitive spending on big ticket items. Vehicle sales and homebuying are the most vulnerable and they are already responding. Spillovers from homebuying, including purchases of all types of home goods, will follow. Financial spillovers from marking fixed coupon instruments to market are also underway. These effects are headwinds pushing back on the demand side of the economy and the inflation embedded in it.
Interest rate tightening can constrain demand, but today’s inflation has supply side drivers as well, including war and Covid. Energy and food inflation reflect in part the war in Ukraine. Higher interest rates will ease price pressures only by slowing aggregate demand for these items and everything else. At the same time, Covid disruption is lingering, especially in China where lockdowns are again underway. The resulting slowdown in exports from China is exacerbating supply chain glitches that were beginning to abate earlier this year. Higher interest rates may take some pressure off demand for imports as economic growth slows but tools to address war and Covid directly are not in the monetary policy toolbox.
The full impact of these challenges on property performance and investor decisions are slowly emerging. One early hint may be seen in the flattening in property prices noted in the March CPPI calculated from transaction closing prices by Real Capital Analytics. That index was up 17.4% year-over-year in March but down 0.4% separately for the month of March, the first decline since June 2020. Price declines were confined to the retail and suburban office sectors while the red-hot industrial and apartment sectors continued to show increasing prices.4 This disparity illustrates the ongoing influence of structural changes affecting property sectors.
RCA US Commercial Property Price Indices
Source: RCA US CPPI Report as of March 31, 2022.
Looking forward, the Blue Chip Survey of 47 economic forecasters expects 2.6% real GDP growth this year reported in May. This is down from the 3.2% reported in April and 3.5% in March. Next year, forecasters are expecting a 2.1% growth rate which is in line with the long-term 2.2% trend growth achieved for the last two decades. 2,5 Projections for inflation and interest rates in 2022 have changed more sharply. Forecasters projected 7.1% consumer price index (CPI) inflation for 2022 in the May survey and a 2.7% average for the 10-year Treasury yield. In December, the consensus called for 4.4% CPI inflation and a 1.9% average 10-year Treasury yield. Forecasters are expressing confidence in a soft-landing with 2023 CPI inflation pegged at 3.2% with 2.1% trend-like growth.5 These positive expectations are rooted in tight labor market conditions producing solid wage growth, positive consumer expectations, and ongoing strong investment in equipment, software, and R&D.
If they materialize, such conditions imply that the national business cycle will provide a benign environment for US CRE through this year and next. But structural challenges and opportunities will remain at play.
For apartments, anemic single-family home construction over the last decade combined with maturation of the huge millennial generation contributed to soaring single-family price inflation in 2021. Rising mortgage rates on top of inflated home prices are restraining demand this year. Apartment owners are benefiting as demand for rentals is strong. Sustained economic growth corresponding to a soft-landing should support apartment returns through this year and next.
For industrial, adjustment to the acceleration in online shopping and speedy delivery is combining with a drift away from holding “just in time” inventories to “just in case” as a lesson learned from covid-related supply chain glitches. These structural forces have contributed to enormous warehouse demand, augmented by 2021’s strong economic growth as the covid recession was resolved with strong fiscal and monetary policy supports. Demand demonstrated in leasing and property transaction prices appears to be insatiable but also reflective of “fear of losing out”. First quarter NCREIF appreciation was weaker than the prior quarter suggesting easing momentum which will likely continue with weaker economic growth and resolving structural adjustments.
For office, the structural forces are anything but benign. In mid-April, office occupancy hovered at 43% according to the Kastle Back to Work Barometer as employers slowly attempted return to the office.6 Fear of another covid contagion wave is easing despite a new pickup in contagion while almost all Covid restrictions and mandates are lifted. At the same time, businesses are parroting support for hybrid work arrangements allowing office employees to spend part of the workweek working from home. A consensus appears to be forming around the expectation that such flexibility will appeal to most employees. While it will take some time to access whether such flexibility is sustainable and its impact on space needs, businesses are proactively offering space for sublease. Nationally, the availability rate was 15.6% in the first quarter while the vacancy rate was 12.2%. Leasing activity has picked up, however, and is in line with the long-term average according to Costar. Yet, space demand is confronting a sizeable inflow of new supply conceived pre-covid which will keep a lid on rent growth. If covid fades, work-from-home will be the focus of office market uncertainty in the quarters ahead. Longer-term, the sector will need to address energy use, climate risk, and net zero carbon goals.
The retail sector is looking much improved in NCREIF-NPI results for the first quarter as its total return moved ahead of the office sector. However, performance remains widely disparate across retail subsectors. Regional malls continue to underperform with many lower quality properties struggling with vacated department store boxes. Strip centers with grocery stores are doing better and have been for some time.1 As Covid fear eases, demographics are once again the most important drivers of retail property performances combined as always with the quality of retailers.
1National Council of Real Estate Investment Fiduciaries. March 31, 2022
2US Bureau of Economic Analysis. Gross Domestic Product. April 28, 2022
3Board of Governors of the Federal Reserve System. May 16, 2022
4Real Capital Analytics. March 31, 2022
5Wolters Kluwer. Blue Chip Economic Indicators. April 11, 2022
6Kastle. Kastle Back to Work Barometer. May 11, 2022