Commercial Real Estate: 2019 Trend Watch

Exterior view of an office building with large glass windows and rust-colored stone siding with green bushes.

The U.S. commercial real estate market has always been a challenging asset class for the non-specialist investor.

While the returns on offer often lead the non-dedicated investor to cast an envious eye, those looking in from outside have correctly assumed that deep sector knowledge is a prerequisite to enter this investment space. And beyond expertise and experience of the managers, another major barrier to entry has been scale: Investors need to be able to deploy large capital investments in order to create diversified portfolios of what can often be large, illiquid assets.

The industry is changing, however. Many of the traditional obstacles that prevented smaller institutional investors, family offices and high net worth individuals from participating in the sector are not quite the deterrent they once were. In fact, a strong combination of structural, cyclical and technical factors is driving new classes investors into commercial real estate.

If you’ve taken an interest in this widening arena of opportunity, here’s what you really need to know…

Structural

The first factor driving investors from outside the specialist commercial real estate and large institutional funds is a desire for portfolio diversification. As investors hear warnings of volatility building in equity and bond valuations there is a natural inclination to seek out value in alternative asset classes. Commercial real estate offers diversification into an asset class not directly correlated with the rest of a traditional investment portfolio — particularly its fixed income investments. Real estate assets tend to rise when interest rates decline. Investors also tend to find the physical nature of the assets attractive as a diversification play: In short, it offers simpler and less volatile valuation analysis than other alternative assets such as private equity, commodities, or FX.

Cyclical

It wasn’t long ago that both the US and international markets could reasonably be described as obsessed with the path of the US Federal Reserve’s rate hikes. And some of that focus lingers, obviously.

In the current moment, however, every day seems to convert more to the view that the next move in US interests will be down, not up. Surprisingly dormant inflation rates amid ever-decreasing unemployment have set economists revising their presumptions of both the cyclical and long-term path for interest rates.

What is the new normal? We still don’t know, of course.

As the consensus builds on “lower-for-longer” interest rates and prices in many US real estate markets become more favorable, though, the allure of commercial real estate asset increases.

This combination of price expectations on both a nominal—price increases ahead—and relative — equities and bonds have perhaps less obvious upside space—basis establishes real momentum in capital allocation to commercial real estate.

Technicals

While structural and cyclical factors are an important source of motivation for some investors entering this investment class for the first time, technical developments have also played a strong role in triggering capital flows.

The growth in small and medium direct lenders at the lower end of commercial real estate valuations—critically with lenders that have in-house servicing teams—opens up lower “ticket price” investments. The bigger investors, which often require large minimum investments, have yet to migrate down the value spectrum. And this creates opportunity for smaller institutional investors, family offices, and other private banking clients.

With Collateralised Loan Obligations (CLOs) increasingly generating liquidity for an asset class that has long suffered from illiquidity risk, there has also been a strong return to structured take-outs in this market. Non-specialist investors have long been fearful that economic decline would be exacerbated by lack of bid when the cycle turns. The prospect of packaging commercial real estate at this level into securities, however, builds both liquidity and diversification to ease concerns about price volatility in the sector. Greater awareness of the strong creditor rights of commercial real estate has also lessened concerns about insolvency performance.

Combination of factors

Fifth Third works with many investors seeking to revamp portfolios as bond and equity valuations become stretched. A lower value commercial real estate that offers a mix of positive structural, cyclical, and technical factors could very well make for an attractive risk/reward profile in the eyes of investors who not so long ago would likely not have thought the market was realistically open to them.

If you think you’d potentially like to be part of this new day dawning in commercial real estate, it’s could be an auspicious moment to consult with a seasoned advisor with experience in the field.

The views expressed by the author are not necessarily those of Fifth Third Bank and are solely the opinions of the author. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever.