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Investors looking to real estate for its traditional benefits of income, diversification and growth may wonder whether financial conditions have eclipsed fundamentals and taken the core market from underappreciated to overvalued in just a few years. Valuations in US core commercial real estate have been affected by years of ultra-low interest rates. Strong inflows have generated some eye-catching sale prices on trophy properties and pushed cap rates close to their 2008 lows.

In fact, the picture is more complex, and richer in opportunities, than a quick summary suggests. For one thing, while cap rates in gateway cities like San Francisco and New York are at or near record lows, in second-tier metros such as Denver and Austin they have not returned to prerecession levels. Even in gateway cities, valuations in prime locations may vary greatly from those in up-and-coming areas. In most markets and sectors, moreover, rents and net operating income (NOI) are likely to rise, as an expanding economy strengthens demand while new supply remains scarce.

As the benefit from cap rate compression plays out, we expect NOI growth to drive unlevered returns in the 6% to 7% range over the next three years—attractive relative returns in the current environment. Furthermore, we believe investors attuned to the forces at work both during this cycle and over the long term can still find properties capable of providing even stronger returns. Locating them is a matter of exploring the following:

  • A broader set of metros, submarkets and assets to seek out relative value.
  • A given investment’s potential for growth in net operating income.
  • Key long-term social and economic trends—notably urbanization, globalization, technological change, and the US energy boom—that may affect both cap rates and NOI growth prospects in different markets, submarkets and property types.
Look To NOI Growth For Future Returns

Investing in the middle of a cycle inevitably means making finer distinctions than might be required earlier on. This is especially true in today’s US core real estate market, where a mix of post-crisis financial conditions, long-term trends and fundamental factors has created an unusually divergent cycle. Given the strong inflows of capital into major markets in recent years, overall returns are likely to decelerate—but that should not obscure the many attractive opportunities still available for investors who are willing to look to a wider range of markets and assets and able to apply the right criteria when selecting transactions.