When it comes to reading all the information about commercial real estate market trends, it can be overwhelming for new investors. Sorting through the data takes a practiced eye, so I recommend that new investors rely on an expert for guidance. There are good metrics even a novice should understand that apply to private real estate investing and can affect your decision-making. Here are a few:
Cap Rate Environment
The capitalization rate, or “cap rate,” is the rate of return on a real estate investment property based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor’s potential return on his or her investment.
The capitalization rate of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property, where NOI is the annual return on the property minus all operating costs.
The formula for calculating the capitalization rate can be expressed in the following way:
Capitalization Rate = Net Operating Income / Current Market Value
The capitalization rate is always expressed as a percentage.
When expected yields fall, cap rates also typically fall. This can be a telling indicator for sellers and buyers of private real estate.
Pay attention to the loan decisions banks and other financial lenders are willing to make; this can also be a good trend to watch.
According to National Real Estate Investor, “lending sources were extremely skeptical about funding new construction (particularly hotel and hospitality) coming out of the last recession, and the current lending environment is showing signs of reticence as bank reserve requirements from Basel III and CMBS risk retention requirements from Dodd-Frank [were] due to kick in by late 2016.”
Hesitancy on the part of a lender will almost always tend toward the conservative side, but knowledge of it can still help guide your own decision-making.
While private real estate isn’t highly correlated with the stock market, there are still indicators we can see from the overall national economic health that can indicate positive or negative trends in private real estate investments.
When buying or investing in a local property, work to understand the local economy for that specific asset class. The property itself may be a great buy. But if the current economic conditions for that building type (asset class) are slow, be prepared for potentially slow returns and dividends. A slow economy could indicate fewer tenants or a slower conversion of new tenants to the building. An optimistic economy could mean a quicker turn time for the investment you’re looking at.
Some businesses over the last few years have realized that financial success can be accompanied by social and environmental success. According to PWC’s Emerging Trends in Real Estate 2017, “corporate leaders understand the impact [of urban revitalization], but also stress the self-interested economic case: attracting talent, penetrating urban markets, and the superior returns obtainable in live/work/play locations. Diverse cities, ranging from Cleveland and Oakland to San Diego and Raleigh, have benefited.” This trend could indicate an opportunity for private real estate investors.
Keep in mind that each of these factors can vary greatly by region; all real estate is local. It’s impacted by local economies and trends. But national and worldwide market trends can sometimes affect local economies too.
You must be patient and understand that returns can fluctuate during an investment period. That said, rather than trying to mastermind your own investment strategy through market cycles, it’s more important to do extreme vetting of your investment manager, regardless of your investment timing in a given cycle. An investor should always think about an investment manager’s contingencies, levers or safeguards put in place to grow principal in an investment and strive to protect it at all costs, regardless of market cycles.
At MLG Capital, we believe our strategy shouldn’t change – but rather, our degree of aggression within that strategy will change, depending upon our analysis of economic indicators.