Will the commercial real estate market always go up? Of course not. But investors have been spoiled by two decades of double-digit returns that were too good to last. In 2016, returns on institutional-grade property fell below a 20-year 10.1% average for only the first time since the Great Recession, and the latest Urban Land Institute’s Real Estate Economic Forecast puts estimated 2018 and 2019 returns around 6%.
Commercial real estate is cyclical, so it’s logical to expect a downturn at some point. But conventional wisdom holds that it won’t come soon. Colliers International’s 2018 Outlook on U.S. property markets says 2017 was the market’s peak, but the commercial real estate industry is expected to show continued growth, albeit at a more moderate pace, making a real estate market crash less likely.
Although the commercial real estate market’s outlook is still respectable, should investors be deterred by a potential decrease in returns from investment properties in the coming years? As the founder of a real estate investment firm, my informed answer is no. In fact, I believe investors should own private commercial real estate in every market cycle for the following reasons:
1. Market timing doesn’t work.
The top of the market is obvious only in hindsight. Think about stocks in the Great Recession — the Dow Jones Industrial Average (DJIA) bottomed out at 6,469. That would have been the worst year to get out. But that’s easy to say now, with the DJIA hovering around 25,000 and the S&P 500 — only 683 in 2009 — close to 2,700 today. The truth is that we won’t know we’re in a downturn until we’re there. The only way to generate long-term average returns is to be in for the long run.
Real estate’s illiquidity and the fact that it takes time to sell properties can be a positive; it forces investors to keep cooler heads. Panic selling is one of the quickest ways to erode long-term returns as liquidity allows investors to make immediate — and often unfortunate — choices when markets are down. The illiquidity of real estate investments acts like a built-in stopgap to keep investors from making the wrong choices when times are tough.
2. Private real estate protects portfolios in market downturns.
Low volatility, high expected returns and low correlation to the stock market are the three most important variables to consider when adding any alternative asset to a portfolio. Real estate has little to no correlation to stocks and bonds, historically. The longer hold periods insulate real estate from the volatility and abrupt price shifts of other asset classes. Private real estate is immune to the daily shocks of trading, delivering high absolute returns that tend to hold their value throughout market cycles. This tempers portfolio volatility in virtually all markets and can make it a safe haven in down markets.
3. Sound strategies will pay off.
Not all funds acquitted themselves in the recession. According to Preqin, funds in the lowest tier — the bottom 25% — underperformed safe investments both during and after the recession. The top tier consistently beat safety benchmarks and quickly bounced back to double-digit internal rates of return. Yet even during the recession, half the closed-end private real estate funds tracked by Preqin turned in positive net internal rates of return. It is important to choose the right fund and real estate manager — it’s often less important what you invest in than whom you invest with.
Funds also come in many flavors. Investors planning a major purchase or nearing retirement can look for funds with redemption dates that fit their timetable to build and preserve wealth. Value investors can look for funds with cautious strategies that look for off-market opportunities or motivated sellers. Opportunistic funds that raise new-construction capital will be the most vulnerable to a future market glut. Core real estate funds are managed to generate steady income, while value-add funds offer no income but look to generate substantially higher returns by acquiring and fixing underperforming properties.
The bottom line for a long-term strategy in real estate is no different from any other investment: Don’t panic when times get tough. Understand your investment goals, and stay the course throughout market cycles. Investors who commit to funds and reinvest their earnings will have a greater chance of realizing high returns.
Source: Forbes Real Estate Council