The dog days of summer are here. The garden is ripe with the tomatoes, cucumbers, and peppers we have dutifully tended. The summer season is truly a time of gastronomical delight, tempting us to try to extend the period of harvest. Should we leave the fruits longer on the vine? Should we plant more seeds? No. The time of planting and toiling is past. Now is the time to enjoy the fruit of our labor, just as the owners of direct property in the United States, who braved the winter winds of 2008–09, are enjoying today. Their efforts are being handsomely rewarded with a real return of nearly 10% a year since 2010, surpassing any of the three decades following the late 1970s when good recordkeeping began. Unfortunately, we do not expect the strong harvest from commercial property to continue in the decade ahead.
The Past Harvest
Capitalization rates (income per unit of price) of commercial properties have declined over the last 35 years. The average capitalization rate in the 1980s was 7.0%, in the 1990s 7.8%, in the 2000s 6.8%, but in the 5 years ending 2015 only 5.5%. High prices and high capital returns— although great for owners who wish to sell—when unsupported by income lead to low current yields and inevitably to lower long-term returns as capital price gains outstrip the necessary support of cash flows.
We define cash flow as net operating income following the definition used by the National Council of Real Estate Investment Fiduciaries (NCREIF),1 which is the gross income earned from rent and amenities (e.g., parking, laundry facilities, and vending machines) reduced by operating expenses (e.g., repairs and maintenance, insurance, and property taxes). We define price return as the real capital return, or the real appreciation in average market value per square foot.
These income and price change series are probably the easiest and most accessible judgments of the health and return of direct investment in commercial property. Unfortunately, the gross real return of investing in direct property has fallen far short of the promises of income and price. From 2010 to 2015, the investor real return experience in US commercial property has been 9.8% a year, a lofty number and substantially higher than in the preceding decades, but nonetheless 5.3% a year short of that implied by the income and price appreciation of the properties. The average shortfall for the 35-year period beginning in 1980 is 4.1%.