Report: CRE Investors Lower Return Expectations

New research finds that investors’ return expectations softened during the first half of 2007 despite growing evidence that commercial property fundamentals were improving during that period. The disconnect suggests that improving operating fundamentals weren’t enough to quell investor concerns about shifting winds in the real estate capital markets.

Last Thursday, for example, CB Richard Ellis released a survey showing that five of the 10 largest global office markets posted 20% increases in asking rents during the 12-month period that ended at midyear. Occupancy rates also ticked upwards in each of the 10 office hubs where vacancy was already in single-digit territory before midyear 2006.

“Rent increases of more than 20% in bellwether cities like London, New York and others significantly underscore the continued strength of the global office market,” says Ward Caswell, director of U.S. Research at Los Angeles-based CB Richard Ellis (NYSE: CBG).

Investors have drawn less confidence from this positive momentum. According to the summer 2007 Real Estate Report from the Real Estate Research Corporation (RERC), which was unveiled last week, return expectations were down across the board during the first half of 2007. Return expectations for commercial properties are determined by capitalization rates, the purchase price divided by the projected income during the first year of ownership.

Investors encountered heated competition for deals earlier this year. The RERC reports that average cap rate expectations declined by as much as 40 basis points during the second quarter. It also represented the fourth straight quarter in which yield expectations have declined.

“Returns on commercial real estate are relatively strong, and in the first half of 2007, we are still seeing some of the highest prices ever paid for high-quality properties,” says RERC president and CEO Kenneth Riggs.

But Riggs adds that “reduced pricing power and credit for average and lower-tier properties” has put downward pricing pressure on lower quality properties in marginal locations. Cap rate expectations fell dramatically among hotel investors, who anticipated a 7.4% going-in yield on new hotel deals by the end of the second quarter.

That represented a 60 basis point quarterly decline, too. Perhaps even more surprising — given the bullish CB Richard Ellis report — was that central business district office investors dropped return expectations by 50 basis points to 6% during the quarter.

“We have had it too good for too long,” says Riggs. “There is a clear shift on investment pinned to strong market fundamentals versus building all of one’s investment hopes on the capital markets and low interest rates.”

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