Commercial real estate investors are likely to obtain much lower returns on their investments over the next four years, according to John Flavin, principal of San Francisco-based real estate consulting and advisory firm Wolfback.
Institutional-grade commercial real estate provided investors with a whopping 25 percent return in 2010, Flavin said. But investors should be prepared to see those numbers drop to only five percent beginning this year.
What's an investor to do? Flavin says they need to develop new ways to handle investment risk.
"Commercial real estate investors typically look at vacancy levels, supply, and demand in making decisions," said Flavin, "but this type of data can be unreliable in a turbulent economic environment."
In 2009, Flavin set about to identify other economic indicators that would help predict future investment returns. He tested a number of variables and found that two of them – commercial real estate debt level and the rate of unemployment – are highly correlated to commercial real estate returns. The Wolfback model projected healthy returns for 2010, but much more modest ones for the following four years.
Recently, a Massachusetts Institute of Technology (MIT) index, widely used in the real estate industry, validated Flavin's projection for 2010. The MIT Transactions-Based Index (TBI) showed that institutional real estate assets did, in fact, deliver annual returns of 25 percent in 2010 – very close to Wolfback's projection.
"Last year's healthy returns reflect strong institutional investor demand for trophy office and apartment properties," Flavin explained. "The more modest return levels projected for 2011-2014 are attributable to limited credit availability, uncertain demand, and constrained new development activity."
"We are pleased that the most recent TBI returns support our model, but the important message is that we have identified early indicators as to the direction of property returns," he said. "Armed with this information, investors can make decisions regarding their assets before the market changes."
Flavin, who holds a Harvard MBA and a law degree from Duke University, is using his new model to help investors with scenario planning and risk management. "Our goal is to help investors preserve and protect their returns," he said.
Wolfback LLC is a real estate education, consulting and advisory firm based in the San Francisco Bay area. Wolfback has developed tools and methodologies to simplify investment analysis, quantify risks, and create scenarios that allow clients to anticipate the future in advance of the market. For more information, see www.wolfbackllc.com.
Note: Flavin opted to use the TBI index as the measure of real estate returns because it offers some advantages over the median-price or appraisal-based indexes, such as the NCREIF Property Index. The NCREIF Property Index's approach reports annual 2010 returns as 13.1% - compared to TBI's market approach of 25.2% - for the same portfolio of properties.