Summary: The headwinds with commercial real estate continue.
NCREIF's Q2 2023 total return, which includes income and appreciation, came it at <1.98%> vs the prior quarter's <1.81%>. Things got worse. Annual total return for the past 4 quarters is now <6.6%>. At the end of Q1 2023 - it was <1.60%>.
The largest change occurred with Office property appreciation for Q2 which was <7.0%> and for the year it is <18.4%>. Even with this substantial reduction in office property values, the income return from Q2 2022 was 1.08% and is now 1.21%--a change of only 12% indicating a decline in net operating income.
There are only other 2 time periods that had negative returns for all property types which were during the S&L crises and in 2008 Financial crises.
2. For the past 4 quarters all property types have incurred negative returns with office sustaining a <14.5%> total return. Office properties have sustained a <18.4%> 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 2nd quarter property value write-downs, income returns were not materially changed. The key issue is: are NOI returns 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 Q4 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 Q2 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 Q2 and dropped further to 3.02% 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.
9. INDUSTRIAL: The record returns are OVER. Income returns are record lows (lowest of ANY property type that I can recall), appreciation is dropping off FAST and that will pull down the TOTAL returns.
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 Q2 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 Properties' 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 the office. Income returns are no longer near 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 last 3 quarters.
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 during the COVID time period.
Economist Bill Knudson provides regular economic analysis.
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