Is It Too Late to Invest in Commercial Real Estate?

not-too-late

Commercial real estate investing has the potential to offer long-term returns that are both healthy and stable. But with property prices at post-recession highs, investors often ask us if it’s still a good time to invest in commercial real estate.

Our answer: Yes, it’s still a good time.

While market analyst Real Capital Analytics believes commercial property markets are overvalued in New York, Boston, Oakland and San Francisco, RCA believes commercial property is undervalued in Atlanta, Jacksonville, Ohio and Chicago. This is in keeping with the Urban Land Institute’s prediction earlier this year that midsize markets with lower costs of doing business are profitable bets for real estate investors. Origin targets these midsize markets.

As disciplined private equity investors, we’re still finding commercial real estate deals that make sense.  We believe commercial real estate investing will continue to be lucrative for quite a while thanks to specific market fundamentals.

These five factors explain why we expect commercial real estate values to continue to rise:

1. Economic growth is solid. The U.S. economy is improving, but by no means overheating. Gross domestic product rose 1.1 percent in the government’s final estimate for this year’s first quarter.  While that number hides a slowdown in nonresidential fixed investments, a category that includes office assets, it also includes positive contributions from residential fixed investments, which covers multifamily properties and residential real estate construction.

2. Hiring sets the table for more growth. Notably, construction hiring is strong in the Labor Department’s latest report — up 3.4 percent from a year earlier. Altogether, the private sector has added more than 2.3 million net new employees in a year’s time. These workers will need places to work, and the sectors that are hiring will dictate where and which kinds of real estate will be in demand.

Not only this, but the rise of the Millennials and their different lifestyle choices are driving the need for apartment buildings and office space in urban areas.

Jobs in education and health have grown 2.8 percent, followed by leisure and hospitality (2.7 percent), professional services (2.5 percent), and retail and financial services (both 2.0 percent). Developers will meet new private-sector demand for offices, stores and apartments.

3. Office rents are still rising. In hot secondary markets, leases on new buildings are fetching a 34 percent premium, according to Jones Lang LaSalle’s 2016 Q2 U.S. Office Outlook. This indicates that Origin can improve its leverage to raise rents with value-added improvements in the eight U.S. markets where we invest – cities with talented workers and an attractive quality of life.

Take for example Denver, one of Origin’s eight target markets. JLL says Denver rents have pushed higher, to $26.28 a square foot at midyear. The strong market will improve income and appreciation in Origin’s well-located Denver Tech Center property. By adding conference space and worker amenities, we can price rents to match the market and still give tenants a strong value.

4. Risk is being rewarded. Real estate isn’t the only asset class priced at historic highs. The improving economy has helped set new records for the Dow and S&P 500. Yet high prices don’t keep investors out of the stock market. Corporate profits justify the price.

The capitalization rate, the ratio of net operating income to the asset value of property, is roughly 350-400 basis points higher than yields on 10-year Treasury notes. This is commonly referred to as the risk premium and is simply the excess return required by investors above the risk free rate.

In 2007, the spread was only 100 basis points and historically it’s been 250-300 basis points. Investors are still getting paid to take risk in today’s market.

5. Great deals are still out there. It’s harder to find bargains in commercial real estate these days. But quality assets are available, especially for organizations like ours that have a disciplined approach to vetting potential assets. We also have built relationships in the private equity real estate market and can acquire institutional-grade assets off market (and avoid bidding wars). Then we put smart managers in place to realize those assets’ full value.

So no, it is not too late to invest in commercial real estate. By taking a disciplined, patient approach, investors in private real estate can realize impressive returns in both growing and maturing markets.

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Michael Episcope is cofounder & principal of Origin Investments and a 17-year veteran of real estate investment.