As 2013 gets underway, real estate investors are wondering about the outlook for the coming year and the best strategy to employ in the current environment. The new normal is a slow growing economy, a $16 trillion federal government debt load and steady but generally weak job growth. In 2012, the national economy grew by 2.2 percent compared to 1.8 percent growth in 2011. The projection from the Real Estate Research Corp. (RERC) is that slow economic growth around 2 percent will continue through 2013 with continued weak job growth, low interest rates and volatility in the stock market.
This slow growth, low interest rate environment seems to favor investment real estate over other investment assets. The tangible, transparent nature of real estate makes it relatively safe as an investment alternative to stocks and bonds, particularly in this period of volatility and uncertainty. Over the past 15 years, investment real estate has outperformed all other investment assets as determined by the various market indices. The index compiled by the National Council of Real Estate Investment Fiduciaries shows that investment real estate has enjoyed an average annual return of 9.35 percent compared to the 10-year treasury bond annual return of 4.28 percent, and the Dow Jones Industrial Average annual return of just 5.92 percent.
The current low interest rate environment also helps investment real estate by creating a favorable positive leverage gap between borrowing costs and net rental income. This low interest rate environment is likely to continue for at least another two years as the low-growth economy forces the Federal Reserve to print money and keep interest rates at unprecedented low levels.
So long as positive job growth continues, vacancy rates for all types of investment properties will continue to decline. As vacancy rates decline, rental rates will start to increase. This, in combination with declining capitalization rates (the net rental income divided by the property price), will move the value of investment real estate higher. So even though we find ourselves in a slow growth environment, low interest rates and declining commercial vacancies should make 2013 another good year to invest in investment real estate from industrial, office and retail to multi-family.
However, despite this favorable investment environment, there are some gray clouds on the horizon. Due to the favorable interest rate to rental rate ratio, more capital is working its way back into investment real estate. The result is that we are starting to see lower and lower capitalization rates being paid, particularly for the best quality properties, as more and more money chases after fewer and fewer prime investment properties. The trend toward lower capitalization rates driven by a combination of low interest rates and competition among investors could lead to some ugly consequences. Higher interest rates are inevitable at some point in the future. The current 10-year treasury yield of 2.04 percent is less than a third of the long-term average 10-year treasury yield of roughly 7 percent. A significant rise in interest rates will force capitalization rates up and investment real estate values down. Although 2013 should be another good year to invest in real estate, prudent investors should make sure they’ve properly underwritten the risks of a particular investment.
William Small, JD, CCIM is managing director of Frias Investment Advisors, a division of Frias Properties of Aspen that specializes in advising investors and owners of investment real estate. You can reach him at (970) 429-2419 or email him at firstname.lastname@example.org.