Make Room For Real Estate

by: Richard Turnill

Key points

  • We believe the U.S. commercial real estate recovery still has room to run amid reflation and resilient rental yields.
  • The Fed raised rates. Stocks rose, bonds rallied and the U.S. dollar fell on Chair Janet Yellen's perceived dovish remarks.
  • U.S. durable goods orders could provide another sign of the disconnect between sentiment surveys and hard economic data.

The U.S. commercial real estate recovery is in its eighth year, but we believe it still has room to run amid reflation, competitive rental yields and potential for operating income growth.

Components of commercial real estate return during U.S. rate hiking cycles

Sources: BlackRock Investment Institute and NCREIF, March 2017.
Notes: Total return is represented by the total return of the NCREIF Property Index (NPI), which tracks commercial real estate properties held for investment purposes. The income yield is based on the cash flows generated by the properties in the NPI. Other components are net operating income (NOI) growth (year-over-year growth in NOI) and changes in the capitalization rate (which is NOI divided by the property's value).

Resilient rental income has helped support U.S. real estate returns during past rate-hiking cycles, especially during more gradual ones like today's. See the green bars in the chart above. And commercial properties are typically able to raise rents in reflationary periods, albeit often with a lag, providing some inflation protection.

Reasons for real estate

U.S. commercial property prices have returned to 2008 peak levels, yet we see key differences with the debt-driven previous cycle that ended in a bust. Real estate development activity is lower and credit access is tighter. Valuations, measured by the ratio of operating income to property values versus 10-year U.S. Treasuries, are around the 20-year average.

We see U.S. commercial real estate delivering attractive total returns over the next few years in a low-return world. We expect capital appreciation to slow but see operating income growth due to the reflationary backdrop and the potential for property managers to add value by upgrading buildings. Average yields of 3.5% are competitive with 3.4% for U.S. investment grade and an S&P 500 dividend yield of 2%. Demand is strong: Nearly half of institutions in our most recent Global Institutional Rebalancing Survey intended to raise allocations to real estate this year.

We favor industrial and office properties that should benefit from reflation. We are neutral on apartments due to elevated supply and avoid retail properties due to e-commerce competition. We like selected publicly traded U.S. real estate investment trusts and commercial mortgage-backed securities.

  • The Fed raised interest rates as expected. The U.S. dollar index fell to a one-month low on the perceived dovish tone of Chair Yellen's remarks. U.S. Treasury yields fell and global shares rallied.
  • Dutch Prime Minister Mark Rutte looks set to form the next Dutch government after his center-right party beat Geert Wilders' far-right populist party. European stocks rose and the euro strengthened.
  • Oil prices stabilized after sharp declines, supporting energy-related stocks and high yield bonds.

Global snapshot

Weekly and 12-month performance of selected assets

Equities Week YTD 12 Months Div. Yield
U.S. Large Caps 0.3% 6.2% 16.5% 2.1%
U.S. Small Caps 2.0% 2.8% 29.4% 1.3%
Non-U.S. World 2.5% 8.0% 13.5% 3.1%
Non-U.S. Developed 2.1% 7.3% 11.2% 3.2%
Japan 1.5% 6.1% 14.9% 2.0%
Emerging 4.3% 12.2% 21.0% 2.6%
Asia ex-Japan 4.0% 13.5% 20.5% 2.5%
Bonds Week YTD 12 Months Yield
U.S. Treasuries 0.5% 0.0% -1.3% 2.5%
U.S. TIPS 0.7% 0.5% 2.1% 2.4%
U.S. Investment Grade 0.6% 0.4% 3.8% 3.4%
U.S. High Yield 0.2% 2.0% 15.9% 5.9%
U.S. Municipals 0.3% 0.8% -0.1% 2.6%
Non-U.S. Developed 1.7% 1.7% -4.2% 0.8%
Emerging Market $ Bonds 0.8% 3.2% 9.1% 5.5%
Commodities Week YTD 12 Months Level
Brent Crude Oil 0.8% -8.9% 24.6% $51.76
Gold 2.0% 7.1% -2.3% $1,229
Copper 3.5% 7.2% 17.1% $5,935
Currencies Week YTD 12 Months Level
Euro/USD 0.6% 2.1% -5.1% 1.07
USD/Yen -1.8% -3.6% 1.2% 112.70
Pound/USD 1.9% 0.5% -14.4% 1.24

Source: Bloomberg. As of March 17, 2017.
Notes: Weekly data through Thursday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

This post originally appeared on the BlackRock Blog.