The Rising Tide Is Not Lifting All Boats: Finding Opportunity in the Commercial Real Estate Recovery
Total returns on US commercial real estate have now increased for roughly 8 consecutive quarters. Historically, once total returns turn positive after a downturn like the one we just came through, they tend to stay positive. For anyone with capital to deploy, that raises the obvious question: where are the opportunities now?
To answer it, I recently welcomed Rich Hill, Senior Managing Director and Global Head of Real Estate Research and Strategy at Principal Asset Management, to America's Commercial Real Estate Show. Principal manages around $110 billion of commercial real estate globally, placing it among the top 10 real estate managers in the world, and its four quadrant approach across public and private equity and debt gives Rich a wide lens on the cycle.
His conclusion is that commercial real estate has moved from downturn into recovery, and this recovery rewards selectivity far more than the last one did.
The Cycle Math: Long Expansions Powered by Income
Rich makes the point that real estate cycles are much longer than most people assume, lasting around 16 years on average. Recoveries run about 2 years, expansions about 12 years, and downturns about a year and a half. Price appreciation gets the attention, but income returns are what allow total returns to power through the inevitable swings in value over a long cycle.
That is why Principal expects net operating income (NOI) growth to be the key driver of returns in the years ahead. With little room left for cap rate compression, income growth drives both income returns and capital returns. The market lost sight of income during a decade of historically low rates and cheap financing, and Rich sees today as a back to basics environment much like the early 1990s.
Dispersion Beneath Muted Headline Returns
If returns have been rising for 2 years, why do the headline numbers feel so ordinary? Rich points to a wide dispersion of results underneath the averages. The top quartile of property types across markets is doing very well, and even the top half is performing, but the bottom quartile has had a failure to launch because it has little or no NOI growth. Average those together and the headline return looks muted.
Dispersion is easy to ignore in a broad expansion when everyone makes money, and the last recovery, after the Global Financial Crisis, rewarded taking risk. This one requires picking the winners and avoiding the losers. As Rich puts it, selective conviction is the new overweight.
Housing: Solving the Mismatch Market by Market
The popular claim is that the US is underhoused by 5, 7, or 8 million homes. Rich says the math is correct, but the real issue is a mismatch: too much of certain housing types in some markets and too little of others elsewhere. Building millions of units in Seattle would only create a glut in Seattle. Principal therefore looks at housing holistically:
· Class A Apartments: Rich expects generic Class A returns to underwhelm expectations because cap rates are tight and medium-term growth may fall short of what the market anticipates. Principal will buy Class A at the right basis, ideally below replacement cost, with realistic rent assumptions.
· Higher Quality Class B: Value-add opportunities remain in better Class B assets. Rich also cautions that any concern about AI-driven white-collar job losses for office should also be applied to commodity Class A apartments.
· Build-to-Rent: The 21st Century ROAD to Housing Act limits large institutional owners from buying more existing single-family homes, but it preserved their ability to participate in build-to-rent. Rich expects build-to-rent to become a bigger part of housing supply over the next 10 to 20 years, since you solve affordability by building what you do not have.
· Senior Housing: Only 2 cohorts of the US population are growing, those aged 70 and older and those aged 35 to 50. Senior housing is primarily private pay, funded by home equity and investment accounts that have grown over the past 3 or 4 decades.
Retail's Quiet Comeback: Power Centers and Unanchored Centers
Institutional investors remain underweight retail because it is still treated as a red-lined asset class, yet the fundamentals have shifted dramatically in the landlord's favor. Very little new retail was built from 2010 to 2020 during the so-called retail apocalypse, and COVID then forced a right-sizing of supply. Occupancies are high and landlords can push rents again.
Of the roughly 115,000 shopping centers in the US, Rich estimates only 5% to 10% fit an institutional buy box. Grocery-anchored and community centers trade at compressed cap rates, while power centers and unanchored centers offer better cap rates, room for NOI growth, and pricing well below replacement cost.
Office and the Replacement Cost Safety Net
Rich believes investors are painting office with too broad a brush. He cites a broker statistic that 90% of office vacancy is concentrated in 30% of buildings, 60% is concentrated in 10% of buildings, and 40% of office buildings have no vacancy at all. In his words, the US has a Class B and C office problem. On AI, he expects the market to overestimate the near-term impact and underestimate the long-term impact, and some markets, San Francisco among them, are already benefiting.
Across sectors, the lack of new supply traces back to one fact: existing properties trade below replacement cost. That provides a safety net on how much further values can fall and signals that rents should rise over time until existing buildings approach replacement cost. We are seeing this firsthand at Bull Realty, where we are working on an office tower priced at roughly 10% of replacement cost and recently handled a boutique hotel in St. Simons at about 50% of replacement cost. As Rich put it, commercial real estate comes down to the right basis and the right NOI growth relative to that basis.
Living With a 5% 10-Year Treasury
The elephant in the room is interest rates. On the day we recorded, the 10-year Treasury was above 5%, a psychological line for many investors. Rich's answer is to double down on the same thesis: focus on properties with higher returns through a combination of cap rate and NOI growth.
I see the adjustment in my own business. The government-leased buildings we sell around the country are stable, high-credit investments, and cap rates on the ones we are taking to market now are around 9%, where we were selling similar buildings at 6% not long ago. Sellers understand where the market is. Rich's broader point is that the last cycle was the abnormal one. Commercial real estate worked for decades with the 10-year Treasury at 4% to 5% and inflation around 3%. Early in my career, we were happy to get a 12% interest rate, and deals still worked.
Final Thoughts: Back to Basics
This recovery rewards the right basis, disciplined rent assumptions, and assets with room to grow income. Properties trading below replacement cost, limited new supply, and a normalizing rate environment create real opportunity for investors willing to be selective in every sector, from build-to-rent and power centers to top-tier office. As Rich reminded us, there is more to commercial real estate than interest rates. Lending matters, and fundamentals matter.
Have a Commercial Real Estate Strategy to Discuss?
With more than $8 billion in closed commercial real estate transactions, Michael Bull, CCIM, brings extensive transaction and market expertise to owners, investors, and companies across the United States. As host of America's Commercial Real Estate Show and an active commercial real estate broker with a strong presence in Atlanta and markets throughout the Southeast, Michael offers experienced perspective on property strategies, market conditions, acquisitions, dispositions, and other commercial real estate opportunities.
Contact Michael to discuss your commercial real estate objectives.
Michael Bull, CCIM
Michael@BullRealty.com
404-876-1640 x 101