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The overall commercial real estate (CRE) market became slightly more attractive from a return vs. risk perspective in 1Q 2019 compared to the previous quarter, but sentiment about risk-adjusted returns varied by property type.
That’s according to data gathered for the May 2019 Situs RERC Real Estate Report, “Defensive Positioning,” which was released recently. The Situs RERC institutional survey respondents’ ratings are based on a scale of 1 to 10, with 10 indicating that return far exceeds risk.
In 1Q 2019, Situs RERC’s institutional respondents rated return vs. risk for overall CRE at 4.8, compared to 4.7 in both 4Q 2018 and 1Q 2018. According to the Situs RERC institutional respondents, risk has outweighed return every quarter since 3Q 2017, except for a blip in 3Q 2018 when return outweighed risk. For comparison, the return vs. risk rating was near or above average for nearly eight years prior to 2Q 2017. The current quarter’s return vs. risk rating increased closer to equilibrium, but remains below the post-recession average of 5.3.
Respondents indicated that the office sector had the lowest return relative to risk among the property types in 1Q 2019. The return vs. risk rating for the office sector declined from 4.9 in 4Q 2018 to 4.4 in 1Q 2019 and is down year over year (YoY) from 5.2. The rating has generally been declining since 3Q 2016 and is at its lowest mark since 2Q 2009.
The sector faces both headwinds and tailwinds. Steady employment continues to support the office sector; however, structural changes to the office market (space optimization, technology) present challenges. Investors will need to keep an eye on evolving trends in flexible office arrangements.
The industrial sector secured the best return vs. risk rating among the property types in 1Q 2019. The return vs. risk rating for the industrial sector increased quarter over quarter (QoQ) from 5.0 to 5.9, the highest rating in over a year and equal to the post-recession average. The industrial sector rating has been at or above equilibrium in every post-recession quarter.
The sector still has pricing power amid robust investor demand and the most favorable near-term fundamentals of all the property types. Vacancy rates are expected to remain near record lows for warehouse and data centers. As e-commerce continues to carve out a larger share of retailing, warehouse demand is expected to remain strong.
The retail sector’s return vs. risk rating was 4.7 in 1Q 2019, up from 4.4 in 4Q 2018 and 4.0 YoY. Despite the sector receiving an average or above average rating for 17 straight quarters from 1Q 2013 to 1Q 2017, the retail rating has remained below average since 2Q 2017, indicating investors’ pessimism in the sector.
Structural changes to the sector, including e-commerce, oversupply of space, shifting consumer shopping patterns and grocery delivery chains, present long-term challenges across all types of retail. Overall retail rents are expected to grow by about 1.5% over the year, but capital appreciation is expected to decrease.
The apartment sector’s return vs. risk rating was 5.4 in 1Q 2019, the same both QoQ and YoY. The return vs. risk rating has been remarkably stable over the past year, with respondents indicating the sector offers a greater risk-adjusted returns. The current quarter’s rating is below the post-recession average of 5.6.
The outlook for the sector appears to be steady in the short term, with continued investor appetite, plenty of liquidity and rising property values. We expect apartment cap rates to stabilize or slightly increase in 2019; however, given the transaction volume and pricing, apartments will likely continue to be a preferred property type for investors.
The Situs RERC Real Estate Report is the commercial real estate industry’s most respected and relied-upon survey-based resource of CRE investment criteria for risk analysis for over 45 years. This quarterly report is packed with a variety of valuation metrics, including cap rates, pre-tax yield/discount rates, and investor insights on the institutional, regional, and 47 major markets. To subscribe to the report, go to store.rerc.com or call 319.352.1500.