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INVESTED Winter 2013
Asset Class Overview:
BY Benjamin Gelhaus, CFA
Analyst
Commercial Real Estate
Commercial real estate has made a quicker recovery than the residential housing
market and, as values have stabilized and investors have begun putting money back
to work in the asset class, it presents some attractive investment opportunities.
Recent Background
From 2008 to 2010, the commercial real estate market was consistently labeled as “the next shoe to drop” in the financial
crisis. Many believed the loose credit underwriting standards that plagued the residential mortgage market had also infected
the commercial mortgage market. Many also believed commercial real estate was overpriced and overleveraged, which
would lead to a massive number of defaults as tenants downsized and loans matured, triggering additional losses at already
undercapitalized banks. While there have been a number of defaults across the commercial mortgage market since 2008,
the private sector has been able to work through the majority of these problems through recapitalizations, refinancings,
and changes in ownership (albeit in some cases by order of a judge).
As a whole, the current commercial real estate market is back on solid footing and was able to rebound faster than the
residential housing market—thanks in part to low interest rates. Counterintuitively, the bigger driving factor in the
rebound was that banks tightened credit standards and required additional equity from buyers and developers. This created
a lack of available financing for new commercial real estate ventures and thus a limited supply in many markets. While the
lack of new development has harmed other sectors of the economy, such as construction and building material firms, »
INVESTED Winter 2013
it has been a positive for professional landlords, who have
begun to decrease vacancy and increase rental rates (Exhibit
10). These positive trends have helped raise the value of
well-positioned properties. Seeing that values have stabilized
and even increased in markets across the nation has incentivized
formerly sideline investors to begin looking at new
investments in real estate assets.
EXHIBIT 10
COMMERCIAL REAL ESTATE MARKET TRENDS
20
16
12
8
4
0
 Apartment  Office  Retail
’08
’09
’10
VACANCY RATES
’11
’12
The returns of commercial real estate can vary widely, just
like in the stock market, but they have historically performed
very well in comparison with both equity and fixed income
investments. Exhibit 11 compares private real estate returns
on a rolling five-year basis by the initial investment year
to the five-year rolling performances of the stock market and
long-term corporate bonds. The return profiles of real estate
compared favorably to both stocks and bonds from the late
1990s through early 2000s. Of course, this exhibit also shows
the subsequent declines in value as real estate investments
made during the peak of the market, from 2005 to 2007,
experienced losses and less favorable returns.
EXHIBIT 11
ROLLING FIVE-YEAR PERFORMANCE
30%
6
25%
3
20%
0
15%
-3
10%
-6
5%
-9
 Apartment  Office  Retail
-12
’08
’09
’10
RENT GROWTH
’11
’12
0%
-5%
Source: Reis Services, LLC
-10%
Investing in Commercial Real Estate
Russell 3000 BofA Merrill Lynch U.S. Corporate BBB Rated 7-10 Yrs PREQIN Real Estate Performance Benchmark
Historically, investment opportunities within commercial
real estate were limited to the inner circles of high-net-worth
individuals and private institutions with access to experienced
real estate professionals who could manage and invest across
this asset class. While this style of investing is more accessible
today through private real estate funds, investors may also
gain exposure to commercial real estate through REITs.
REITs are professionally managed pools of capital, most
often listed on the public markets1, which invest in commercial
real estate. Like the stock of any company, a REIT may have
a different focus or a different risk associated with its total return.
In 1960, President Eisenhower signed the Real Estate
Investment Trust (REIT) Act into law. This act created a
new real estate investment vehicle—known simply as
a REIT. As of September 30, 2012, 158 REITs
representing more than $570 billion in equity market
capitalization traded on the public markets2.
Source: PREQIN U.S. Real Estate Performance Benchmark data, based on median fund
returns by vintage year.
Due to their illiquidity, private real estate returns lag on a total
return basis until the properties in the underlying investment
vehicle are sold or repriced via an appraisal, which makes
an apples-to-apples comparison problematic. In contrast,
public real estate securities, such as REITs, offer an instant
glimpse at the perceived market value of real estate assets,
but will likely have additional volatility associated with them,
based on the state of the equity market at any point in time.
Even so, real estate is often considered a less volatile asset
class than equity securities, since repricing of real estate
through purchases and sales is less frequent.
Assessing Commercial Real Estate Values
Real estate performance will always vary from market to
market, but also by property sector. The amount of rent that
is charged by property type will depend on a number of
factors, such as age, location, and usage. Interest rates also »
INVESTED Winter 2013
EXHIBIT 12
CAPITALIZATION RATE TRENDS
Sector
Spot Rate, as of 4Q 2011
10%
Apartments
6.5%
5%
10%
Industrial
7.6%
5%
10%
Office CBD
6.2%
5%
10%
Office Suburban
7.6%
5%
10%
Retail
7.4%
5%
’01
’02
’03
’04
’05
’06
’07
’08
’09
’10
’11
Source: Real Capital Analytics and RREEF Real Estate. Data as of March 2012.
As shown, capitalization rates are still above the lows seen in
2007 for most property sectors. If we examine the approximate
spread (a measure of risk) between the capitalization rates
in Exhibit 12 and the current 10-year U.S. Treasury bond3,
we see a spread range of 4.8%-5.9% (Exhibit 13). Comparatively,
looking back to the approximate low in capitalization rates
on December 31, 2007, and then the 10-year U.S. Treasury
yield of 4.7%3, the spread ranged between 0.3%-1.3%,
depending on the property sector. Examining the large
disparity between current spreads and the historic low
spreads seen in 2007, we see that capitalization rates have room
to fall, given the current low-interest-rate environment. It remains
to be seen whether real estate investors will continue to invest in
commercial real estate and drive capitalization rates lower.
While there have been many examples of a continued decline in
capitalization rates through one-off transactions, it remains to
be seen how successful those investments will be. It’s possible that
any investment gains could be offset by a higher capitalization
rate in the future, decreasing the value of the property at sale.
EXHIBIT 13
12%
11%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
REAL ESTATE IMPLIED CAP RATES
6.8%
1.82%
 Transaction cap  10-year Treasury yield
1/90
10/90
7/91
4/92
1/93
10/93
7/94
4/95
1/96
10/96
7/97
4/98
1/99
10/99
7/00
4/01
1/02
10/02
7/03
4/04
1/05
10/05
7/06
4/07
1/08
10/08
7/09
4/10
1/11
10/11
CURRENT
play a role in real estate investing, as a real estate manager will
source the cheapest available debt at the most favorable terms.
A lower interest rate will increase the amount of cash flow that
can be paid back to investors after paying interest and taxes, and
it will also help determine the capitalization rate. Capitalization
rates are used to help value a property; they represent the
current return from existing net cash flows investors could earn
if they owned the property with no outstanding debt. The
lower the capitalization rate, the higher the implied value of
the property. Exhibit 12 displays capitalization rates across
property types over the past several years.
Source: Citi Investment Research. Data as of August 17, 2012.
Of course, investing in real estate is not without risks, but
when purchased at the right price, high-quality real estate
can return consistent income with less volatility than
traditional equities. Given the current low-interest-rate
environment, real estate may be an appropriate asset class
for investors searching for income and potential upside
appreciation over the next several years. Before considering
the addition of real estate to an investment portfolio, an
investor should complete diligent research on a well-located
property, and, perhaps more importantly, find the correct
professionals to manage that property. Finding the right
combination of these factors can add a long-term consistent
return stream to a portfolio of assets while helping to protect
against downside risk in an uneasy market.
__________________________________________________________________________
1 REIT.com (http://www.reit.com/timeline/timeline.php) 2 FTSE NAREIT - REIT.com
3 Bloomberg
Sources: RREEF—U.S. Real Estate Strategic Outlook: Mid-Year Review 2012. September
2012. Research Report RREEF—U.S. Real Estate Strategic Outlook 2012. March 2012.
Research Report REIS Services, LLC 2012
The opinions and analyses expressed in this communication are based on RMB Capital Management, LLC’s research and professional experience, and are expressed as of the date of our mailing of this
communication. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is it intended to speak to any future
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