Strong Increase in Commercial Property Values Suggests CRE Downturn Is Over

by: Brad Case

Returns on investment-grade commercial properties shot up an incredible 12.0% during the last quarter of 2010, according to the latest release of the Transaction-Based Index (NYSE:TBI) computed by MIT's Center for Real Estate. Last week I expressed skepticism about the very healthy 4.62% total return reported by the NCREIF Property Index (NPI) - but the latest data leaves little doubt that the downturn is truly over for investment-grade commercial real estate. For 2010 as a whole, the TBI says that commercial property returned more than 25%; returns are up nearly 28% from the market trough (2009q2), though still down nearly 16% from the pre-downturn peak (2007q2).

What's important here is not really the 12.0% estimate for the quarter - that's subject to random sampling error, and could easily be "corrected" next quarter. What's important is the fact that a transaction-based index confirms the signal that we got last week from the NPI. The TBI is computed from the same database as the NPI, which encompasses more than 6,000 core properties held by data contributing members of the National Council of Real Estate Investment Fiduciaries. The difference between the NPI and the TBI is that the NPI is computed using appraised values, whereas the TBI is computed using actual transaction prices from those properties that were bought or sold. (During 2010 that amounted to 291 transactions worth $10.5 billion.) Actual transactions can sometimes bring appraisals into question - but that didn't happen this time.

As I noted last week, good news from indexes like the NPI and the TBI doesn't mean that all commercial property investors face smooth sailing ahead. Many investors on the private side of the market still face default, bankruptcy, and sales under pressure, stemming from their decisions during 2006-2008. If you went on a buying spree at the peak of the market, and used too much debt while paying top dollar, then even 2010's gain of 25% won't rescue you: you're still a dead duck when your mortgage comes due. Going forward, we remain likely to see lots of distressed sales, as well as investment managers admitting they lost pretty much everything. That distress won't affect the NPI or the TBI as much as investors in private equity funds, because the holdings reflected in the NPI and TBI tend to be concentrated in the higher-quality, more stable part of the market rather than the lower-quality bulk of the market from which most of the distress will come.

For investors in publicly traded REITs, though, bad news is good news: Distress on the private side means more profitable buying opportunities on the public side. Meanwhile, REITs should also benefit from the improving picture in occupancy rates and rent increases. That means REIT investors can look forward to two different sources of strong earnings growth: accretive acquisitions and improved operating fundamentals.

Disclosure: I am long Vanguard REIT Index Fund and ING Global Real Estate Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.

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