Executive Summary
Introduction
With Covid-19 being a black swan market event, investors are genuinely worried about their real rate of return from all markets. The ongoing oil price dip and the possibility of a moderate recession also looms large in the retail and the office markets. The natural question in this blog is: Is it still a good time to invest in the commercial real estate market overall? Our answer is in the affirmative based on the following facts.
1. Median Home Sales Price has softened all across the US
Source: FRED Database.
It appears from the above graph that while the median sales price for new houses sold in the U.S. has an increasing trend since September 2012, wage growth is also keeping up to this trend. Thus, for savvy investors, it may be worthwhile to exchange some of their home assets with other commercial assets, such as multifamily properties with greater purchase price than their home assets. With such 1031 exchange, these investors may be able to defer their tax bill.
2. Decline in the Mortgage Rate with Fed’s Current Policy
Source: Authors’ construction based on Freddie Mac’s Data.
Mortgage rates have declined by over 1% across various mortgage types since their highs in 2018. If interest rates remain low for the near future, many investors will refinance their properties resulting in either substantial cashback refinances or significantly improved cash-on-cash returns on their rental properties. Either way, it is a big win for investors.
3. Stock Markets are Still Performing Well Despite Recent Setbacks from the Covid-19 Virus
Source: Authors’ construction based on Yahoo Data.
Although the supply chain shock owing to the coronavirus spread is widespread in the travel, retail, and hospitality sectors, the S&P 500 index is still performing quite well. As S&P 500 index is an important indicator of the economy’s health, coupled with unemployment rate being historically low and wage growth continuing its upward trend, there may be no signs of an imminent recession to the broader economy. Of course, if the coronavirus spread affects a significant number of countries, we may experience an overall recession for the global economy. However, this is far from being a certain outcome.
4. National Average Rent Evolution continues its Upward Trend
Source: Authors’ construction based on Apartment Index Data
The value of a multifamily property is ultimately based on the rental income it generates. As evident from the above graph, the national average rental income has increased for studio apartments, 1bedroom apartments, 2 bedroom apartments, 3 bedroom apartments, and 4 bedroom apartments. This is good news for landlords and investors as this growth rate from rental income increases value to their portfolio.
5. Median Household Income has continued to increase
Source: Authors’ construction based on Census Bureau Data.
After a dismal performance in 2010 with median household income at $56,873, during 2018, the median household income stands at $63,179. With the current unemployment rate at 3.6% and wage growth rate on an increasing trend, there may be room for investors willing to put their money in the commercial real estate sector.
6. The Millennial Generation Sector may be buying more Commercial Properties
Source: 2019 NAR Home Buyer and Seller Generational Trends
The millennial generation are now in their 30s, which means they have at least 10 years to save for a down payment of their homes. As evident from the above chart, the older generation millennials are buying 26% homes compared to selling 18%. Compared to the older boomers, who are buying only 14% and selling their homes 22%, if some of these millennials can save their income from their home purchases, they may be able to sell these properties at a higher price and reinvest these cash into commercial properties in the future to generate even higher returns. Thus, there is good reason to believe that the higher rate of return from commercial real estate investment will continue over the next decade.
7. Over a longer time horizon, compounded return on real estate assets is vastly better than Equities
A comprehensive study by Jorda et al. (2017) have clearly demonstrated that residential real estate, not equity has been the best long-run investment over the course of modern history. Although the returns on housing and equities are similar (around 7%), the standard deviation of housing returns in significantly smaller than that of equities (10% for housing versus 22% for equities. Thus, with thinner tails, the geometric average is vastly better for housing than for equities — 6.6% for housing versus 4.6% for equities. This finding contradicts one of the basic assumptions of modern valuation models that higher risks should come with higher rewards.
How does this result translate to the commercial real estate market?
Many commercial real estate projects have NNN rent structure in which the tenant is required to pay the landlord’s cost in addition to the monthly rent. NNN properties gained popularity because they require less management (“zero-landlord responsibility”), provide good returns, and have long term leases in place. Unlike other investment properties, the value of NNN assets is mainly composed of mostly 2 factors:
The returns on NNN properties are higher as well – around 6.5% industry wide, compared to 5.6% in multifamily nationwide, and require significantly less management. Thus, there may be significant potential for investors entering into this market with the current bear S&P 500 index through significant diversification of their portfolio holdings.
Conclusions
With Covid-19 being declared as a pandemic by the World Health Organization (WHO) recently, investors are genuinely panicked owing to the S&P 500 index entering into the bear zone. Coupled with the fact that there is an oil price dip with a potential for Saudi Arabia and Russia entering into price wars on oil prices, we suggest that commercial real estate investment may be a good avenue to diversify the portfolio for investors.
First, investors may be able to exchange some of their home assets with commercial assets, such as multifamily and office properties. This will allow them to defer their tax bill.
Second, with mortgage rates declining from their previous highs in 2018, investors may be able to refinance or significantly improve their cash-on-cash returns on their rental investment properties.
Third, with an increase in average rental income nationwide, landlords and investors may be able to improve the value of their portfolios.
Fourth, with the current unemployment rate at record lows being at 3.6% with wage growth registering an increasing trend, there may be room for investors willing to put their money in the commercial real estate sector.
Fifth over a longer time period, on the demographic side, with millennials saving their income from their home purchases, they may be able to sell these properties at higher prices and reinvest their cash into commercial real estate with potential for higher returns.
Finally, the returns on NNN properties are 6.5% industry wide, compared to 5.6% in multifamily nationwide. These properties also require significantly less management. Thus, there may be significant potential of diversification of institutional investors’ portfolios.
References
Census Bureau, Table H-6: Regions by Median and Mean Income, Available at: https://www.census.gov/data/tables/time-series/demo/income-poverty/historical-income-households.html
FRED, Median Sales Price for New Houses Sold in the United States, Dollars, Monthly, Not Seasonally Adjusted, Available at: https://fred.stlouisfed.org/series/MSPNHSUS
Freddie Mac (2020), Current Mortgage rate data since 1971, Available at: http://www.freddiemac.com/pmms/
Jorda, O., K. Knoll, D. Kuvshinov, M. Schularick, A.M. Taylor. (2017), “The Rate of Return on Everything, 1870-2015”, Federal Reserve Bank of San Francisco Working Paper 2017-25, Available at: https://www.frbsf.org/economic-research/files/wp2017-25.pdf
National Association of Realtors Research Group (2019), 2019 Home Buyers and Sellers Generational Trends Report, Available at: https://www.nar.realtor/sites/default/files/documents/2019-home-buyers-and-sellers-generational-trends-report-08-16-2019.pdf
Salviati, C. (2020), Apartment List National Rent Report, Available at: https://www.apartmentlist.com/rentonomics/rental-price-data/
Yahoo Finance, S&P 500 Historical Prices, Available at: https://finance.yahoo.com/quote/%5EGSPC/history/