CRE Takeaway from Bill Gross's Latest Letter

Bill Gross, PIMCO’s revered managing director, has just published his most recent investment outlook. In it, he calls the end of the recent market rally and warns of a necessity to come to grips with the fact that a new normal is headed our way. The closing sentences sum up his point nicely and he puts a stake in the ground as far as his belief of expected investment returns on a going-forward basis (emphasis mine):

Investors must recognize that if assets appreciate with nominal GDP, a 4–5% return is about all they can expect even with abnormally low policy rates. Rage, rage, against this conclusion if you wish, but the six-month rally in risk assets – while still continuously supported by Fed and Treasury policymakers – is likely at its pinnacle. Out, out, brief candle.

In many of my previous posts, I have essentially been calling for a realization of this “new normal” as it relates to CRE. Gone are the days of proformas void of vacancy or reserves. There is no more assumption that every tenant can handle 100% pass-through of all operating expenses. Assets need to be valued based upon market rental rates instead of current, inflated rents (on a case by case basis, of course). Higher CAP rates, lower rents and lower asset values, etc., etc.

I keep hearing things like “when the market comes back” and “CAP rates and rental rates will recover.” Sure, someday they will. But what is apparent to me is that people seem to believe that “coming back” will be like the flip of a switch. Nothing could be further from the truth, in my opinion. If tenants were signing leases at $36 PSF during the boom years and now those same buildings command just $18.00 PSF, do you really think rents will just double when the market “comes back”? Of course not. Rents will grow from their newly reduced levels and may once again reach our previous highs but they will certainly not just jump back to previous levels over night.

The thought process that the market “coming back” will flip a switch and everything will go back to how it was during the boom years seems to be pervasive in the CRE industry. I really have a hard time understanding how so many people in the CRE industry can’t seem to get this.

Rents will grow in relation to the growth of the economy. Why do you think you hear the term “lost decade” thrown around so much lately? The bottom dropped out of the Japanese economy and it took a “lost decade” for the economy to return to previous levels. The Japanese economy did not just sit at the bottom and then jump up to previous highs overnight. CRE values of the boom years (CAP rates and rental rates) are a long way out in the future. Get used to it.