While residential property markets remain troubled, commercial real estate markets have already entered an up cycle and are poised for "slow, steady improvement" over the next five to seven years, says a new white paper from Forward Management, LLC.

Titled Inflection Point: The Start of a New Cycle in Real Estate?, the paper posits that the recovery will play out in uneven waves across U.S. and international markets.  Knowledge-based "gateway" cities and technology corridors are already recovering as job growth fuels demand across commercial property sectors. As vacancies drop and rents rise in those areas, demand will likely spill over into suburban job centers and secondary markets, the paper suggests.        

"Many investors see commercial real estate as tarred with the same brush as the residential market, but  the dynamics of the two sectors are quite different. Commercial real estate didn't have the same kind of massive, debt-fueled bubble that brought down the residential sector, and commercial property prices and rents recovered fairly quickly after the financial crisis," said Joel Beam, one of the three Forward real estate portfolio managers who authored the paper.   

"Even with weak U.S. job growth, the supply/demand picture appears favorable on the commercial side, especially in the apartment and lodging sectors, while housing is still in the weeds. Meanwhile, commercial properties are relatively inexpensive by historical standards," said Ian Goltra, also a co-author of the paper.  He noted that in 2011, private equity fundraising for direct property purchases hit a new peak of more than $150 billion[1].               

Among other evidence of the commercial property sector's improving prospects, the paper cites:

-  Improving property operating results, due largely to declining vacancies and rising rents.  Same-property operating income across the five major property sectors shrank in 2009 and 2010, but is expected to grow by 2.4% in 2011 and rise further in the ensuing five years, according to forecasts by Green Street Advisors, Inc.    

- Historically low growth in the supply of commercial properties, due to tight credit and weak economic growth. Construction is barely sufficient to replace obsolete properties, pointing to a further decline in vacancies and rise in rents.   

- The continued profitability of many real estate companies during the recession. As one indicator, the paper shows that four of the five largest companies in the FTSE NAREIT Equity REITs Index had greater cash flow from operations in 2009 than they did pre-crisis.      

The paper cautions that expectations for a new real estate cycle are predicated on continued improvement in the economy and job picture, and that the recovery of equity markets generally could be derailed by some unforeseen shock to financial systems. "In spite of the uncertainties, investors still need to earn a return on their money," commented Beam. "We believe that, with its relatively predictable cash flow, real estate remains a sensible way to invest for the long term. If anything, the market turmoil of the last few years has reaffirmed just how sensible it is."   

Individuals who want to invest in commercial real estate should consider publicly-traded REITs among the options, particularly if they are seeking investment income, the paper suggests. Among the advantages of public REITs, it cites their liquidity, predictable cash flow from long-term leases, and low correlation to the broad equity markets, as well as their dividend streams. Under federal law, U.S. REITs must distribute 90% of their taxable income to shareholders if they want to avoid corporate income taxes[2].

"We see real estate as an essential portfolio building block for investors who want to pursue long-term returns, find investment income, and manage portfolio risk through diversification," said J. Alan Reid, Jr., CEO of Forward Management. "As a broad asset class, real estate has returned an average of 11% annually over the past 30 years and has often been a reliable source of dividends. Our analysis suggests that it may continue to hold a variety of opportunities going forward."   

The three authors of the study team-manage four mutual funds with more than $1.3 billion in total assets as of December 31, 2011. Joel Beam is lead portfolio manager of the Forward Select Income Fund, which focuses on REIT preferred securities; Ian Goltra is lead portfolio manager of the Forward Real Estate Long/Short Fund; the two co-manage the Forward Real Estate Fund.Michael McGowan is portfolio manager of the Forward International Real Estate Fund.

The team is unusual in having more than 20 years of shared history that spans four major real estate industry cycles. The lessons learned through that experience are reflected in the team's two-pronged approach to valuation, its analytical disciplines, and its emphasis on on-the-ground fundamental research.