Real Estate Overseas Could Affect U.S. Market
Commercial real estate markets are likely to continue to benefit this year as good economic growth is accompanied by declining vacancies for different property types. That likely means fewer delinquencies for servicers to deal with. Two different research sources offer two perspectives on the outlook for the commercial real estate sector this year.
One of them, the University of Southern California Lusk Center for Real Estate, is concerned that developers might start projects that increase supply in some markets. Another event to watch for is that some global investors could increase their investments in Asia and Europe in order to get higher returns than in the U.S.
Stan Ross, chairman of the board of the Lusk Center believes that "investors will stop signing blank checks" and sees this as a "healthy sign for property markets." He added that investors have traditionally continued to pursue real estate opportunities in the face of signs that property values were leveling off.
And Stuart Gabriel, director of the Lusk Center, believes that while foreign and U.S. investors are continuing to acquire properties, they are showing more discretion. "On the residential side, flipping of properties has come to a virtual halt as markets have cooled," he said. And on the commercial side, investors have bought properties and sold them after a holding period, hoping to realize capital gains.
For 2006, Mr. Gabriel believes that investors will focus on "bond-like investments." He identifies these as "well-located properties that provide steady cash flows as well as capital preservation and competitive returns."
While the Lusk Center expects capitalization rates on commercial properties to go up in 2006 as interest rates rise, they believe that properties will also generate higher operating incomes, which will offset the higher capitalization rates, which means that investors will get similar yields. They expect commercial property markets to benefit from strong economic growth, increased demand for space, a decline in vacancy rates and rising rents.
Another source, Prudential Real Estate Investors, Parsippany, N.J., believes that as commercial properties appreciate at a slower pace this year, total returns from real estate investments will begin a slight decline in 2006. In a market report, the real estate investment division of Prudential Financial says that returns on "private, unleveraged real estate investments" as measured by the NCREIF Property Index, will range between 12% and 15%, down from the 20% return for 2005.
An immediate risk that PREI sees to this outlook is any potential fallout from a slowing housing market, especially the condo market. Such a slowdown would impact the U.S. economy, including the commercial real estate sector.
Youguo Liang, managing director, PREI Research, notes, "All good things must end, including the terrific run that real estate has enjoyed over the past several years. Real estate should continue to perform well in 2006, however, and it remains attractive to investors, particularly with property fundamentals improving and new supply still years away in most markets and property types."
Declining affordability of homes, combined with job growth, is expected to positively impact the multifamily market. However, considering the prospects for a weaker condominium market and higher operating expenses, market selection will be a critical factor for multifamily investors.
In the retail sector, too, a slowdown in the housing market is expected to translate into a slowdown in retail sales growth.
This sector has benefited as home refinancing activity helped fuel consumer spending in the last few years, but as interest rates go up this is not likely to continue. For the second half of 2005, total returns on retail properties have been below those on office properties for the first time since 2001, according to PREI.
As office fundamentals continue to improve, this sector is expected to outperform the retail sector. Vacancy rates in some cities, including New York and Washington, have fallen to single digits, which is likely to lead to strong rent growth over the next few years.
And the lodging sector is likely to continue to enjoy a positive outlook for the next year or two, especially in the luxury niche of the sector. The prospect of little new supply, combined with a contraction in room inventories as condo conversions continue, will likely allow hotel operators to see growth of 20% or more through 2007, PREI expects.
In the industrial sector, demand for warehouse space is expected to remain healthy as businesses gradually increase spending and rebuild inventories.
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