Non-residential real estate values should rise at a modest-to-moderate pace in the coming two years, with stronger operating earnings partially offset by rising interest rates.

Commercial Real Estate Review

Private non-residential construction is growing at a fairly strong pace, except in comparison to its past peak. Total dollars spent have increased by nearly ten percent in the past 12 months. Nationally, office vacancy is edging down, though 16 percent vacancy doesn’t seem to justify the 17 percent increase in office construction. However, remember that the gain in construction is from a very low base.

Industrial vacancy has dropped by almost a percentage point in the past year. Manufacturing construction has increased by nearly eight percent in the past year. Retail also enjoys slowly declining vacancy and more construction—but again from a low base. Industry insiders say that retail is sharply divided between successful properties and others, the others frequently being dated and in the wrong locations.

Hotels are enjoying higher occupancy (up over a percentage point in the past year) as well as average room rates that have increased by three percent, on about one percent more rooms available. This performance helps to explain the nearly 50 percent increase in hotel construction in the past year—but again from a very low base.

Commercial real estate owners have improved their ability to repay debt, with the bank charge-off rate down to just five basis points last quarter.

Rising commercial mortgage interest rates hurt investment property values in 2013, as shown by REIT prices. They have recovered somewhat thanks to strong operating earnings. Combining appraisals of institutional properties with operating earnings indicate that total returns in 2013 averaged 11 percent. That’s higher than the nine-percent long-run average.

Commercial Real Estate Forecast

The outlook for non-residential operating returns is very positive. The expanding economy will boost occupancy and provide opportunities to increase rents. There is relatively little new supply coming to market in most cities, so landlords will be in the catbird seat for a few more years.

The forecast for construction is also positive, though it will be years before it is really strong. Vacancy rates are still high enough, on average, to discourage widespread development.

Property values are a little tougher to anticipate. On the plus side, higher operating revenue should boost values. On the negative side, higher interest rates will be a downward force. Past experience (as I explained in Commercial Property Values With Rising Interest Rates) argues for rising values in this type of market, but don’t expect appreciation to be as strong as the rise in earnings.

The above article was originally published in Forbes and can be found HERE.