Something always seems to get in the way of this expansion, and this time it’s slower global growth, particularly in China, and a cautious business sector. However, the job market is nearly at full employment and wage growth is starting to pick up. This trend supports a rising tide of consumer spending lifting all boats. While the Federal Reserve may decide to hold off raising rates at the June meeting, it’s very likely that they will at the next as the economy is poised for improvement. The recovery has not been ideal but it has led us to a position of global strength.
Fundamentals remain solid for all property types. The long recovery in the economy has led to a long recovery for all property types. Demand has gained momentum for all but retail property, and construction has yet to keep pace, allowing for diminished vacancy across the board. While increased completions are expected to stabilize rent growth in apartments in the near-term with warehouse soon to follow, there is little evidence that the outlook for real estate should be anything but positive.
All property types are experiencing evolving demand. Apartments are gaining due to lowered homeownership across almost all age groups, office use is becoming significantly more efficient, e-commerce has greatly influenced warehouse space demand, and retail has had to evolve to fit the needs of the modern, omni-channel retailer. Investors should be critical of the risk of obsolescence in all property types.
Investors have been drawn to real estate due to the relatively attractive yields and the positive outlook for fundamentals. There are more buyers than sellers and the capital markets are highly competitive, particularly for better properties in major markets. Cap rates continue to decline and are at or near historical lows on an absolute basis, but when viewed relative to treasury yields, are well within historical ranges. Cap rates should rise along with interest rates however lower perceived risk for the asset class and improving property net operating income may temper the degree of change and the impact on values.
Broad-based job growth has been persistent and is a huge positive for the economic outlook. The number of unemployed is now back to pre-recession levels, and the diminishing availability of skilled labor is starting to drive up wages. Labor force growth has accelerated recently although the labor force participation rate has remained weak. A pool of workers that remain under-employed since the recession may be influencing participation but demographic changes are a factor as well. Aging baby boomers are dropping out of the work force and changing family roles have reduced labor force participation among males, a historically high participation cohort.
Sentiment and some seasonality were detrimental to first quarter GDP growth. The sharp contraction in the energy sector, slow global growth, recent increases in regulatory burdens, the uncertain consequences of Brexit, and an unusual political climate are keeping businesses in caution mode, holding back both fixed investment and investment in inventories. The strong U.S. dollar is further weakening export growth and industrial production. Conversely, consumption remains a steady contributor to growth, and should continue to do so as the job market strengthens.
The Fed has been hesitant to take the next step in “normalizing” interest rates as the U.S. economy continues to feel the ripple effects of global economic weakness. However a strong job market and a modest rebound in inflation may be enough to push the Fed into action in the second quarter. Expectations remain for a slow and prolonged path to higher interest rates. Higher rates will of course raise borrowing costs, but will also improve investment income for the large, retiring baby boomer generation and support financial services profits.
Other uncertainties include the political and regulatory environment. The presidential election has been anything but typical and could generate significant uncertainty both domestically and internationally. Financial market regulation continues to be a hot issue driving change in financial services businesses. “Too big to fail” protections have resulted in burdensome filings for some, and their efficacy remains unproven. A change in political control may lead to initiatives to rewrite some of the new regulations. It is not yet clear how real estate will be affected.
The expansion may be long in the tooth, but it followed an unprecedented recession. The foundation for growth and a positive outlook is in place – a strengthening labor market and strong corporate balance sheets. The challenges facing Europe, China and the oil industry should work themselves out without requiring any major economic dislocations.
Vacancy rates continue to drop for all property types. With the exception of second tier retail property, vacancy rates are within range of long-term averages, triggering rent growth and new construction. Although preleasing is still the norm, speculative construction and re-development is occurring in the better locations for all property types.
Investment returns on real estate continue to be stellar. The five-year annualized total return for the NPI was 11.93% as of first quarter 2016, beating out stocks and bonds. Appreciation has been driving returns with a growing number of investors targeting the strong relative value of real estate. Appreciation has been strong across markets and property types.
The capital markets have become heated. The higher relative yields on real estate has drawn more buyers than sellers, and large portfolio acquisitions and consolidation among real estate companies are common. International investment doubled over the past year, and according to Preqin, a leading provider of real estate data, a record high $230 billion of dry powder is currently being held in private real estate funds.
Cap rates are at or below levels during the last peak, but the spread between the 10-year treasury and cap rates remains wide by historic standards. Pricing trends indicate that buyers are pricing lower risk assets in major markets more aggressively but are generally not overreaching in secondary markets. Cap rates are likely to rise along with interest rates but improving operating income will help support property values.
Technology is impacting all property types, accelerating obsolescence for some. Greater use of precision logistics in warehouse property, fulfillment and omni-channel functions in retail property, and advances in communications and document storage in office property are all examples of trends that are impacting the demand and use of real estate. Investors should target flexible property that can accommodate the technological needs of tenants.
Transparency and liquidity of commercial real estate investment has improved greatly over the recent past, effectively lowering an element of risk for the asset class which should mean lower risk premiums. Therefore, the impact of rising interest rates on real estate values may be muted, particularly when fundamental conditions are so strong.
Positive demographic trends and slower than anticipated economic growth have led more households to the rental market than expected, keeping vacancy in apartment property well below long-term averages. Average annual net absorption of apartment units totaled 175,000 units over the 2010-2015 period compared to 42,890 during the peak of the housing boom in 2003-2005. Demand has been broad, and virtually all markets have maintained full occupancy to date.
There is a significant pipeline of apartment property under construction that is expected to keep completions above net absorption over the next several years with peak deliveries expected in 2016. Average quarterly starts of multifamily property have dropped for three consecutive quarters reducing the risk of oversupply and future market imbalances. Vacancy is likely to bottom this year, and should slowly rise to a stabilized level, slowing rent growth.
Despite the rising completions, rental rate growth has continued to accelerate but the growth is not sustainable. With moderate wage growth to date, affordability will begin to affect absorption. High rents have already driven some renters to Class “B” properties, particularly in the least affordable markets. Rent growth may have peaked in 2015.
Long-term demographic trends favor apartments. The children of the baby boomers, as well as new immigrants, are swelling the age cohort with the highest propensity to rent. There is also some anecdotal evidence that more households are placing greater value on urban amenities accessible through rentals than on suburban neighborhoods accessible through homeownership. The rate of homeownership continues to contract for almost all age cohorts.
According to data from Real Capital Analytics, apartment property sales volumes rose in the first quarter, contrary to contracting trends for the other property types. Transaction volumes rose faster in secondary markets but cap rates contracted more in major markets, suggesting investors were driven to secondary markets to fulfill investment allocations.
Job growth in office using sectors has been volatile over the past year. However, despite the lack of momentum, the absolute level of jobs created is significant. Over the past 12 months, job growth in the professional and business services, information, and financial activities sectors totaled 790,000, lifting net absorption of office space. Net absorption has been expanding each year since 2009 and in 2015 was the highest it’s been since 2006.
Vacancy rates are below long-term averages, stimulating rent growth and some new construction. A majority of new construction is build-to-suit but there has been an increase in speculative construction concentrated in major CBDs. Rising completions and a cautious business sector helped keep vacancy rates flat over the first quarter and modestly weakened the outlook for improvement in vacancy over the next year. Any momentum gained in the job market could have a big impact on office fundamentals.
According to CBRE Econometric Advisers, rent growth over the past 12 months exceeded 5% in 18 markets, with that number forecast to remain stable over the next two years. With office fundamentals at an inflection point, the outlook for rental rate growth is greatly dependent on business confidence. Depending on the vintage of in-place leases, some properties have above market leases and some below, creating widely different opportunities for investors.
The use of office space has been evolving due to advances in technology and a wave of corporate consolidation. Tenants have increasingly valued space that allows for optimal utility to save operating costs, promote a green image, or to improve operating efficiency. In some cases, that involves reduced space requirements, such as working remotely, or electronic document storage. The evolution of office use is not likely to lead to a reduction in overall occupied office space, but it could curtail the growth rate of future office space needs.
Office sharing is a small but rapidly growing demand sector, supported by companies such as WeWork, NextSpace, and Uber Office. Providing office space and services on a pay-per-use basis is another example of technology and operating efficiency redefining typical office use. The rate of obsolescence in office space will likely accelerate as tenant requirements for more technology and greater efficiency increase.
Investors continue to broaden their investment targets beyond the major markets. With significantly more buyers than sellers in those markets, prices have been aggressive. As leasing risks have diminished, suburban and secondary markets are looking more attractive. Investors should choose assets in prime locations, with space well-matched to the market’s tenancy, with easy access, competitive amenities, preferably near public transportation.
Demand Warehouse property is clearly in expansion mode. Construction has been high in regional distribution centers such as Riverside, Dallas, Houston, Chicago, Atlanta and Phoenix, as well as growing logistics hubs Indianapolis and Kansas City. Tight conditions are keeping rent growth strong and will continue to stimulate speculative construction until vacancy and rent growth return to more sustainable rates over the next two years. Historically, construction in warehouse is sensitive to demand and no major imbalances are expected.
Demand for warehouse space continued to exceed completions through the first quarter of 2016, driving vacancy to historic lows according to CBRE Econometric Advisors. However, those conditions are likely to reverse this year. Weaker global growth and a contracting energy sector are dampening trade and manufacturing, and will likely slow net absorption in the year ahead. Demand may weaken at port markets due to slower growth in China but that could be offset by improved domestic demand and an improving job market.
The potential for increased trade flows through the East Coast due to the Panama Canal expansion, changing supply-chain models, and the expectation for continued strong investment in e-commerce are boosting construction of modern warehouse property. Expanding e-commerce has created a new wave of demand for flexible, large box space within a day’s drive of large populations. Amazon has created a new facility standard that is able to accommodate “same day delivery”, a strong competitive advantage in e-commerce.
Labor strike risk and congestion at the major West Coast ports have driven some business to seek alternative routes. While demand is expected to remain strong on the West Coast, businesses are likely to continue to build multiple supply channels going forward, improving the competitive position of alternative ports and distribution hubs. Many ports continue to scramble to complete expansion projects ahead of the impending completion of the Panama Canal expansion in June.
Retail Core retail sales, which exclude the volatile auto and gasoline sectors, have been relatively healthy, growing at 4% per year. Overall, sales reflect improving employment, wages and the strong financial condition of households. Online sales continue to expand rapidly and may account for 20% or more of sales at some retailers.
Trends in e-commerce and weather have been wreaking havoc with sales at traditional apparel and department store retailers, driving their stock prices lower and leading many to once again cut costs and re-access strategies. Store closings are likely to continue as retailers must make difficult decisions to be successful as omni-channel. Store closings in the better locations provide an opportunity to enter a tight market or multiple locations easily and are quickly absorbed. Inflexible or obsolete space configurations are likely to require costly redevelopment to remain competitive.
The high cost of building and maintaining on-line platforms that are fully integrated with physical stores and inventory databases is squeezing profits in a highly competitive industry. Retailers have come a long way from the perception of on-line retail as a competitor to now viewing the on-line channel as a necessary component of a successful business and a significant source of information about customers and their buying habits. The importance of bricks and mortar has been solidified as a critical piece for a competitive retailer.
Retailers have become more critical of their physical stores performance, and the better locations and operators have continued to flourish while the rest languish. Risk has increased for large box space as consolidation, down-sized formats, and competitively priced e-commerce creates leasing challenges. Conversely, the value of outparcels and pads has increased at the better locations as investors see opportunities to add value.
The overall fundamentals are fairly stagnant, but the averages hide the details. Better centers are well-occupied, with stable to improving rents while secondary centers continue to struggle with leasing risk. The strong performance of NCREIF’s NPI Retail Sub-Index is more representative of the solid condition of higher quality assets. Construction has remained low and much of what is occurring has been redevelopment, adding mixed-use, or reconfiguring outdated formats.
Assets serving more non-discretionary needs, such as grocery-anchored centers, have less leasing risk and offer stable income. We believe these assets outside of major markets offer strong relative value. Redevelopment or repositioning of existing centers in built out locations also has the potential for attractive investment returns.
We are in yet another pause in growth, but the weakness is likely to be short-term. The labor market is strong and quickly tightening, driving up the long awaited growth in wages. The oil industry will slowly rebalance and China and the Eurozone are taking steps toward economic improvements. The Federal Reserve will likely resume methodical rate hikes this summer but the impact should not be destabilizing.
All property types now have strong fundamentals. Although apartment and industrial property could be hitting a peak, their outlooks remain positive. Apartment property has been leading the pack into the expansion phase and completions are expected to increase over the next 12 months. Starts have begun to decline, so the risk of overbuilding appears low. However, recent demand has been higher than expected and that may stimulate additional development. If the economy grows as expected, any imbalances that may develop are not likely to last long.
Tight conditions in industrial property are likely to loosen as demand may weaken along with trade and manufacturing over the next year. Warehouse construction is responsive to demand so, again, no major imbalances are expected. The growth of logistics and shifting distribution channels are creating opportunities to develop or re-develop in some markets.
Office property has lagged the rest as secular changes in space needs per worker have coincided with volatile job growth for typical office tenants. Limited new construction is keeping fundamentals firm and rent growth positive.
The retail industry is always evolving but this time it’s more momentous. E-commerce and social media are gaining momentum, driving a significant shift in business models. It has become clear that a retailer needs both an online and physical presence and retailers have to figure out the balance. Space needs are likely to continue to evolve but most trends point to smaller boxes. The increased competition will likely accelerate the failure of underperforming centers.
Increased allocations to real estate, both domestic and international, are supported by strong fundamental conditions and a positive outlook for property net operating income. Total returns on the NPI have, at times, rivaled that of the equity markets and have far surpassed returns on bonds. Real estate offers strong income returns lacking in bond markets today. As the property markets slowly achieve equilibrium, returns are likely to move closer to long-term averages over the next few years, continuing to offer strong relative value in a diversified portfolio.
While technology is affecting all property types, the impact on the retail industry is arguably the most significant. Retailers must spend heavily on technology to compete in an environment that is still defining itself. We expect technology will help retailers make even better locational decisions and alleviate some of the overbuilding that tends to be driven by retailer expansion plans. It is also likely to continue to strengthen the value of better locations for retailers and investors. It’s now clear that a winning strategy must include physical locations.
In the year ahead, investments outside of primary markets may offer the best relative values. Diminishing risks and higher relative yields may be achieved outside the primary markets although strong investor interest may narrow that spread over the next year.