US Real Estate remains a fertile hunting ground
- US economy poised to continue expansion despite rising rates;
- Enhance investment returns through value-add opportunities;
- Alternative investments to provide counter-cyclical returns.
The Goldilocks analogy is arguably fitting in describing a US economy entering its eighth consecutive year of growth. A protracted recovery following the global financial crisis (GFC) has seen the US economy go through the gears slowly, with GDP growth running neither too hot nor too cold. Core inflation is approaching the Federal Reserve (Fed) target of 2%, aided by tight labour market conditions and positive real wage growth. Under the new Trump administration, the policy framework in the US is gradually taking shape, and uncertainty remains high particularly around tax and trade. Nevertheless, business communities have thus far responded favourably to the new administration, with sentiment hitting new highs (Figure 1), and forward-looking surveys indicating rising hiring and investment intentions.
As a result of this steady economic growth, core real estate has recorded healthy net operating income (NOI) growth, averaging around 3% p.a. over the past five years. Gateway1 markets led the recovery and have recorded some of the strongest returns, particularly offices and multifamily, with San Francisco offices recording annual average total returns of 12.8% and multifamily 14.2% over the past five years versus the national All Property average of approximately 11.3%. Gateway markets have benefited more from stronger economic growth than other areas, as well as, lower construction levels and an urbanisation trend with people choosing to live in urban cores at the expense of the suburbs.2
Much depends on the actions of the Trump Administration
If the Trump administration is able to unlock businesses so-called ‘animal spirits’, this should prove to be a fillip for business investment and real estate markets through the latter phase of this economic cycle. Banking de-regulation, as suggested by the Trump administration, may help create additional office demand and provide a supportive environment for value-add.
Proposed fiscal changes, including lowering the headline rate of corporation tax from 39% to 20%, would, at least in the short-term, be a net positive for economic growth and business demand. Of course the US economy still faces headwinds, the main one being a tightening of monetary policy. The combination of improved economic sentiment and relatively robust domestic demand has led the Fed to tighten monetary policy, with the third rate rise having occurred on March 15th, taking the Fed Funds Rate (FFR) to 0.75%-1.00%. AXA IM forecasts two further rises in 2017, with heightened volatility as the market adjusts.
Keen eye required in a crowded market
The global search for yield, in a multi-asset context, has resulted in commercial real estate cap rates hitting new lows (Figure 2).3 With interest rates rising, attention is turning to NOI growth to support cap rates and drive returns. CoStar forecasts imply unleveraged All Property Total Returns for core assets should be between 5%-6% p.a. over the next few years.4 This environment supports the case for value-add opportunities in multifamily, office and grocery-anchored retail, as well as development opportunities and portfolio acquisitions in the industrial sector. Lastly, alternative investments in student accommodation and data centres are preferred for a counter-cyclical strategy.
Offices not completely out of the running
Office demand, peaked in 20155 and has been weaker than in previous cycles. Financial services has suffered under the manifold pressures of increased regulation and near zero interest rates, acting as a drag on total demand. Nevertheless, demand driven predominantly by technology, media and telecommunications (TMT) businesses has driven strong absorption of the best office space and helped to bring vacancy rates in some markets to new lows.6
Select office opportunities remain but are more difficult to isolate, and with demand expected to remain stable, rental value growth for core is forecast at between 2% and 3% p.a.7 and lower where there is a supply side response such as in San Francisco. The next phase of demand is potentially going to be driven by small and medium sized businesses focused on domestic expansion, if the evidence from recent business surveys translates into activity.8 As a result, lower cost but well located office space in Tier Two markets9 with high obsolescence are likely to offer some value-add opportunities.
According to Real Capital Analytics (RCA) analysis of US investment volumes by style,10 despite investors in the US anecdotally suggesting they were targeting value-add opportunities in 2016, they continued to invest in core, specifically in Tier Two markets. AXA IM - Real Assets believes that a strategy targeting A assets in B locations (Tier Two markets), and B assets in A locations (Gateway markets), looks likely to be effective over the next few years.
Diminished homeownership continues to support multifamily investment
Tighter lending conditions, stricter capital requirements and impaired credit scores have made the dream of owning a home just that for many Americans. Indeed, as interest rates rise and mortgages become more expensive, home sales are likely to remain subdued versus pre-GFC levels.11 While there has been a supply response from multifamily developers, especially in coastal Gateway markets, this has focused on luxury, rather than mid-market or affordable product. This is not to say Gateway markets lack opportunities. However, it does suggest rental value growth may dampen in the likes of New York, which looks to be oversupplied in the near term.
Having suffered a prolonged downturn, the Sunbelt markets12 appear poised to see, in relative terms, improved economic growth aided by strong population growth.13 Despite having historically higher vacancy rates and less restrictive zoning regulations, these markets are likely to benefit from domestic migration by retiring baby boomers, attracted by the weather and low cost of living. Repositioning of tired stock into affordable mid-market multifamily, in metros and submarkets with strong demographics, looks to be a compelling opportunity.
Click, click and away for the logistics sector…
The case for investing in industrial and logistics real estate remains strong. Just-in-time and home delivery continue to re-shape both the traditional retail and logistics sectors. Spoke and hub networks, consisting of small final mile distribution units centred on a network of key physical stores and sorting centres, has helped fuel a logistics boom. Pure play and traditional retailers are seeing their worlds collide as the likes of Amazon seek to manage cost and provide greater scale in order to maintain their competitive advantage over the likes of Walmart. In turn, traditional retailers are fighting back, offering a range of delivery options to their customers. Assets in locations that provide efficient linkages via intra-state as well as inter-state transport networks are highly desirable. With e-commerce in the US forecast to exceed approximately 10% of total retail sales by 201914 (up from 8%15 at the end of 2016), tenant demand is expected to remain supportive of rental value growth, despite increased speculative supply scheduled for completion in 2017. This focus on in-land distribution says nothing of targeting traditional industrial for manufacturing in chemicals and plastics, aided by low cost oil and gas, which remains an important growth engine in the US.
…but the death of bricks and mortar retail is exaggerated
Despite the opportunities emerging through the rise of e-commerce, it is important to remember retail is a world in which over 90% of sales are still accounted for by physical stores in the US. Retailers realise they must differentiate through both product and shopper experience. However, high customer servicing costs in the e-commerce space make margins vulnerable in a market where retailers have to regularly discount merchandise. This is also likely to limit the ultimate penetration of online sales, as many products do not lend themselves to this type of sales platform or distribution network. Rapidly changing consumer preferences mean some middle market brands are struggling to remain relevant, especially to the younger consumer. Nowhere is this more apparent than with department stores, where rationalisation has resulted in store closures for the likes of Sears and Macy’s, a trend that could continue over the next few years. Arguably the most compelling space, outside of the major dominant malls, remains the grocery-anchored neighbourhood centre format. The draw of a stable income, driven by non-discretionary sales, remains a profitable long-term proposition for landlords.
Counter-cyclical returns available through alternative assets
Demand on local area internet infrastructure continues to increase. The need for high speed connectivity to facilitate financial services, growth in consumption of online entertainment and consumer traffic, has made data centres a fast growing sector. Silicon Valley and Virginia are traditional data centre hubs, but locations such as Chicago, Dallas and Seattle, among others, are experiencing strong growth, driven by demand for hyperscale cloud facilities. Edge data centres, serving markets with large and growing populations are also seeing increased demand, as services move towards the periphery of established networks. Student accommodation also represents an attractive alternative sector. The US is home to many of the world’s best seats of higher education as well as boasting the largest number of further education students globally. However, only around 10%16 of students live in purpose-built, oncampus accommodation, in line with the international average. Unlike data centres, there are few specialists, and there appears to be significant scope for long-term countercyclical income returns.
Stars and Stripes align for value-add approach
With economic conditions buoyant and sentiment high the US real estate market should continue to offer excellent investment opportunities. As the market cycle has grown in length, cap rates across the sectors (especially in Gateway markets) have reached new lows. While the outlook is broadly supportive of the Gateway markets, returns generated by core assets are forecast to be low over the next five years. It is the view at AXA IM - Real Assets, that a tactical shift focusing on value-add, can offer compelling risk-adjusted investment opportunities. Furthermore, complimenting the value add strategy by exploring alternative sectors such as data centres and student accommodation, should help provide profitable counter-cyclical returns.
3 According to CoStar transaction based cap rates, for an average office, ended 2007 at 5.8%. In the most recent cycle average office cap rates ended 2015 at 5.2%
5-6 CoStar, data as at end January 2017
8 Bloomberg News 21st February 2017, America’s Business Leaders Are Brimming With Post-Election Optimism
9 While there is no industry standard classification for what constitutes a Tier Two market, based on investment volumes, size of real estate market, population and economy, the following can be thought of as examples of Tier Two markets: Houston, Dallas, Denver, Atlanta, Miami, Seattle and San Diego
10 Real Capital Analytics, US Investment Volumes by Style, 2016
11 Total US home sales peaked at 1.28 million units in 2005 pre-GFC. Compare this to 561,000 units sold in 2016, almost 60% less than 2005
12 Sunbelt markets are typically concentrated in the Southeast and Southwest of the United States, and are typified by a warm climate and relatively mild winters, which attracts (with exception of LA) retiring baby boomers. Examples of sunbelt metros include San Jose, San Diego, Los Angeles, Dallas, Houston, Atlanta, Tampa, Miami, Phoenix and Las Vegas
13 U.S. Census Bureau, projections of total population for the United States
14 eMarketer, US Retail Sales to Near $5 trillion in 2016, https://www.emarketer.com/Article/US-Retail-Sales-ear-5-Trillion-2016/1013368
15 Federal Reserve Bank of St.Louis (FRED), Economic Data, e-commerce retail sales as a percent of total sales, https://fred.stlouisfed.org/series/ECOMPCTSA#0
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