Summary: The headwinds with commercial real estate continue.
NCREIF's Q3 2023 total return, which includes income and appreciation, came in at <1.37%> vs the prior quarter's <1.98%>. Annual total return is now <8.4%>. At the end of Q2 2023, it was <6.60%>.
The reason for the deterioration in the annual return is the 3rd qtr 2023 return of <1.37%> replaced the 3rd quarter 2022 return of 0.56%. The annual return is a rolling 4-quarter return, the new quarter comes in replacing the oldest quarter. Looking at the quarter return as of 12.31.23 the annual return should increase given the <3.5%> return for Q4 2022 will drop off. This assumes the Q4 2023 return is an improvement over <3.5%>.
Quarterly total returns of Q3 2023 were negative for all 4 property types with office returns being the worst performing. Annual office total return is <18.4%>.
Industrial was the "least negative" return but it is important to note that Industrial property income returns continue to be near negative lows, not a good position to be in. Below are the rolling 4 quarter income returns since 2011. Even with recent property value write-downs, income returns have not materially improved.
Income returns are not in a position to support higher property appreciations. This is particularly important when compared to the benchmark 10-year US Treasury return. Overall NCREIF cap rates are 4.34%, while for the portion of properties sold in Q3, the overall cap rate was 5.08%. A 17% property value reduction would be needed to get internal cap rates to equal actual 3Q cap rates.
2. The annual returns for all property types were negative returns with office sustaining a <17.1%> total return. Office properties have sustained a <21.1%> appreciation return for the past 4 quarters combined. This reflects changes in product demand and cap rate adjustments due to a higher interest rate environment. Industrial properties continue to have the lowest Income Return which is near its LOWEST LEVEL EVER.
3. Rolling 4 Quarter Income Returns for 3 of the 4 property types are near record lows.
This implies cap rates are also near record lows. Even with the 3rd quarter property value write-downs, income returns have not materially changed. The key issue is: are NOI returns are being driven by property write-downs or by actual increases in NOI.
4. US 10 Year Treasury Rate and Rolling 4 Quarter Income Returns have a high correlation.
Property returns in essence are risk-based relative to the US Treasury 10-year rates---which dramatically increased starting in Q2 2022. The dashed red line is projected rates into Q2 2024 based on the most current Fed’s “dot plot” and the inverted yield curve’s 10-year Treasury spread. This will have a material adverse impact on both income and appreciation returns going forward.
5. ALL PROPERTY TYPES COMBINED: Income returns increased 3bp in Q3 as property appreciation was negative. The low INCOME returns are troublesome due to the rise in competing benchmark asset classes. The appreciation returns remained NEGATIVE in Q3 to 2.44% in Q2 2023.
6. ALL PROPERTIES COMBINED: Annual return went negative in Q4 and WILL continue to do so into the future as prior quarters with high returns drop off. Total returns were driven by INDUSTRIAL properties but even this property type’s returns have gone negative in Q4. Note in the lower graphic that quarterly income returns remain near record lows.
7. NOI Growth Due to Property Devaluation vs NOI Increase: NOI actually increased for industrial and apartment property types. Industrial properties had a 1.60% decrease in property value, and the NOI return increased by 1bp in 2Q.
8. INDUSTRIAL: TOTAL returns HAD been driven by record-shattering Appreciation returns. Income returns have been decreasing indicating that FUTURE income increases are anticipated or decreases in CAP RATES.
With rising 10 Year Treasury rates, whether the lower cap rates can be maintained is subject to debate. It is true that demand for Industrial property increased during the 2020-2022 COVID outbreak as people stayed home and did more online shopping. With COVID becoming less of a public policy issue, it remains to be seen if the online shopping trend will remain at high levels.
10. INDUSTRIAL PROPERTIES as a % of NCREIF: NCREIF’s composition by property type gradually changes over time. Below are the changes from the 12-year period from Q4 2011 to Q1 2023. There has been a material increase in Industrial Properties. Because of this composition change, the Total NCREIF return is higher due to record-shattering industrial property returns. Beware of Industrial Property's record low-income returns.
11. OFFICE: Income returns increased in Q2 driven by the quarter’s negative appreciation of 18% over the past 3 quarters.
12. OFFICE: COVID-induced demand drop, rising 10-year Treasury rates, recession—not looking good for office. Income returns are no longer near the all-time lows due to the property write-downs.
13. APARTMENT: Income returns have increased due to a 9% decrease in property values over the past 3 qtrs.
14. APARTMENT: Total annual returns will fall off FAST as prior high-quarter returns are not maintained.
15. RETAIL: Income returns which had been slowly increasing decreased in Q2 in spite of recent negative appreciation returns.
16. RETAIL: COVID was NOT good for retail which is very slowly recovering. Retail properties did not have valuation spikes leading up to and during the COVID time period.
Economist Bill Knudson provides regular economic analysis.
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