UrbanLand looks at five trends for commercial real estate in 2017.
Five Trends in Commercial Real Estate to Watch in 2017
1/30/2017, David Lynn and Peter Burley
The U.S. property market landscape in 2017 will be characterized by continued strong fundamentals, increased investment flows, and high transaction volume. The broader U.S. economy should continue to grow moderately and add jobs. U.S. employment gains continue to be strong, with unemployment dropping below 5 percent in 2016, adding to demand for commercial real estate in a variety of sectors.
Many are surprised that the economy has not reached the end of the current growth cycle, but the fact that the recovery was so protracted and growth relatively anemic over the past seven years leads us to believe that the economy may have another two years left in the current growth cycle.
The U.S. Federal Reserve made it clear in December that it sees U.S. growth as relatively stable, notching the federal funds rate higher by a quarter point early that month—only the second time since 2006 it has raised rates (the last time was in December 2015). “Economic growth has picked up since the middle of the year,” said Fed chair Janet Yellen. “We expect the economy will continue to perform well.”
Nevertheless, underlying inflation is extremely tame in the United States and major emerging markets (some sectors and countries are worried about deflation), providing no impetus for significantly higher rates. Lending rates and fixed-income rates of return will still be very low by historical standards, inducing continued leveraged purchases of real estate assets.
Regarding the elephant in the room: what are potential impacts of the new administration? Though President Trump has pledged to make massive changes in the U.S. economy, regulatory environment, and government, it remains to be seen—even with a Republican majority in both houses—how much change can really take place.
The following five trends can be expected to play a significant role in commercial real estate in 2017.
Global Economic and Political Uncertainties
The Brexit vote in the United Kingdom has added new uncertainties that will not be fully understood, much less resolved, in the near term.
Prime Minister Theresa May has called for a “hard Brexit,” sooner rather than later, which could add to turmoil in the European Union and spur other countries to reconsider their own relationship with the union. The recent U.S. election has, in a way, signaled the continuing populist revolt of the West, with governments in France, Italy, and Germany potentially leaning more toward nationalist policies and leaders. This could usher in a new wave of deteriorating relationships with these countries.
The United States can probably expect higher tariffs for several countries, including China, Mexico, and South Korea, and potentially many others. Higher tariffs would also mean higher prices for a wide variety of consumer and industrial goods that the United States imports, putting upward pressure on inflation. The International Monetary Fund (IMF) has downgraded global growth twice since January 2016 as uncertainties blur the outlook.
For U.S. markets—and real estate in particular—the impact is likely to be largely positive as U.S. assets become more attractive and valuable to global investors. Enhanced foreign investment in U.S. real estate markets probably can be expected as the United States becomes even more of a safe haven for investors.
Looking ahead, the IMF predicts higher economic growth this year as emerging markets find their footing and commodities continue their recovery. Stronger global growth is likely to provide more real estate inflows for the U.S. market.
Continued Strong Foreign Capital Flows
Global economic and political uncertainty continues to drive capital to the United States, the new administration notwithstanding. International capital flows into U.S. real estate assets will continue—and increase.
The U.S. property market is the most stable and transparent in the world, with higher relative yields and price appreciation potential, making it an easy investment choice. And though slowing growth in China and much of Europe may dampen currency values and incomes overseas, there is still abundant non-U.S. capital looking for placement and very strong demand for U.S. assets, as 2015 proved with record inflows.
In 2015, foreign purchases of U.S. real estate assets rose to more than $87 billion over the 12 months ending in December, according to the Association of Foreign Investors in Real Estate (AFIRE), with China, Canada, Norway, and Singapore all riding the wave. That volume was up from just $4.7 billion in 2009, according to Real Capital Analytics.
Among AFIRE members, a substantial proportion expect to increase investment in the United States in 2017, with investors looking to enhance positions in major gateway cities as well as higher-yielding secondary markets.
Changes in the 1980 Foreign Investment in Real Property Tax Act (FIRPTA), which now allow foreign investors to be treated in a fashion similar to their U.S. counterparts, likely will lead to an increase in foreign investment in U.S. real estate as well. Though Trump has been rattling the saber about foreign goods imported into the United States, he has said nothing against inbound foreign investment in domestic commercial real estate.
The Fed raised its target for short-term interest rates by 0.25 percentage point on December 14. The Fed’s most recent forecast projects U.S. economic growth in 2017 to be 2.1 percent, slightly higher than the Fed’s previous projection in September.
The new administration’s expansionist policy rhetoric—pledging significant spending on new infrastructure, higher exports, higher import tariffs, lower taxes, and reduced regulation—could spur inflation and lead to higher interest rates. Many have predicted the end of the 35-year bond bull run and of record-low interest rates.
Yields, which had fallen to as low as 1.5 percent in the immediate aftermath of the Brexit vote, have risen back above 2.14 percent as of November 2016, according to data from the Federal Reserve Bank of St. Louis. As concerns about global economic developments ease, those yields can be expected to push back toward a more normalized 1.75 to 2.0 percent by early 2017.
Private-equity real estate funds generally follow core, core-plus, value-added, or opportunistic strategies when making investments.
Core refers to an unleveraged, low-risk/low-potential-return strategy that seeks predictable cash flows. Characteristic assets are stable, fully leased, multitenant properties within strong, diversified metropolitan areas. Core plus is a moderate-risk/moderate-return strategy that generally seeks to invest in core properties; however, many of these properties will require some form of enhancement or value-added element.
Value added is a strategy with medium- to high-risk/medium- to high-return potential. It involves buying a property, improving it in some way, and selling it at an opportune time for potential gain. Properties are considered value-added when they exhibit management or operational problems, require physical improvement, suffer from capital constraints, or show a combination of these characteristics.
The squeeze on cap-rate spreads remains of some concern for real estate investments should rates rise more rapidly than expected, as seen with the “frothiness” experienced in certain gateway, Class A markets.
Little indication exists now that a rate increase will push cap rates dramatically higher. Spreads are still historically high for commercial real estate. The historical spread for core real estate over the long-term ten-year rate is about 250 basis points. For most commercial real estate, that spread is still 300 to 350 basis points, so there is quite a way to compress before there is upward pressure on cap rates.
Nonetheless, indications exist that yields may begin to drift upward. And, as pricing in first-tier markets stalls and yields hover in the sub–4 percent range in some of the major gateway markets—which are, in some cases, already in peak pricing territory—investors probably can be expected to move more aggressively into secondary and tertiary markets. They can also be expected to move into opportunities beyond core assets—to core-plus and value-add properties, as well as some of the niche property sectors, including medical real estate and student and senior housing.
Another factor in cap rate behavior is the relative attractiveness of alternative investments available to the investor. Corporate credit bonds currently yield in the 2s, S&P 500 dividends are also in the 2s, and public real estate investment trust (REIT) dividends are in the mid-3s. (Typically, a percentage of REIT dividends includes a return of capital; the value of corporate bonds and their yield fluctuate inversely to each other, and over the long term, the total return on equities has historically exceeded that of REITs and corporate bonds.) In this relatively low-yield scenario, average private-equity real estate yields are still very attractive and continue to attract capital despite rCising rates. That ongoing capital demand will put downward pressure on cap rates.
Volatile Energy Markets
Energy-market volatility has already affected certain regional U.S. economies (Houston and North Dakota) and producer nations (Saudi Arabia and Venezuela). The dramatic drop in oil prices seen in 2016 lasted for most of the year, followed by substantial volatility and higher prices in the final quarter.
Increased production and reduced demand due to slowing global growth led to the decline, which saw oil prices fall from $105.79 per barrel in June 2014 to a 13-year low of $30.32 in February 2016, and a rise to just $49.78 last October. The world has an oversupply of oil, and major producing countries have barely reduced production. This has had a profound economic impact and carries with it implications for property market fundamentals and commercial real estate pricing.
The impacts of this environment vary considerably by region and sector. Negative effects are largely concentrated in a few metropolitan areas with high economic exposure to the energy industry, including Houston, and the oil shale region in North Dakota.
For most metropolitan areas and property types, lower oil prices have been a net positive. Spending less on gasoline encourages consumers to spend more on other items, which helps retail and hotel market fundamentals. Lower oil and energy costs will also reduce certain construction, manufacturing, and logistics costs. This aids business investment and expansion, which in turn increases demand for industrial and manufacturing space.
Property markets will see a short-term lift due to a combination of improving tenant fundamentals and lower operating costs. However, for major energy-producing metro areas like Houston, the short-term benefits of low prices will be discounted by the negative impacts on energy-related firms. The long-term health of the property markets in these metro areas will greatly depend on the speed at which oil prices rebound to sustainable levels for U.S. producers.
The national economy overall is better off in the near term. The United States is still a net importer of oil at about $190 billion per year, and the decline in prices positively influences the nation’s trade balance. Lower prices directly translate into an increase in household disposable income—a savings on gasoline of $50 billion to $75 billion ($400 to $650 per household) in 2016 alone.
The new president has promised significant environmental deregulation for domestic oil, shale gas, and coal producers. He has also pledged to remove longstanding legal barriers to exporting all three to global economies, which could make the United States a net energy exporter. While this might be good in the short term for the producers and processors in the energy sector, it might further depress prices on the global market, creating another glut that could force lower production levels for the United States in the medium term. However, predicted higher global growth in 2017 and after could absorb this additional supply and avert a price collapse.
Slowing New Supply for Commercial Real Estate
Additions to supply will remain limited across the board, with only modest supply growth in a few sectors—multifamily housing (slowing in the new year), senior housing (creeping up), and single-tenant industrial, such as regional/nodal distribution centers—and repurposing in others, such as suburban malls.
Lending sources have been extremely skeptical of funding new construction in the wake of the Great Recession, and the current lending environment is showing signs of reticence as bank reserve requirements from Basel III and commercial mortgage–backed securities (CMBS) risk-retention requirements from Dodd-Frank went into effect in late 2016. Even if Dodd-Frank were to be rescinded or modified in 2017, it would take years for the banking system to return to its old levels of funding commercial real estate and its looser underwriting standards.
Because many local and regional banks left real estate lending altogether and seem to be no worse for it, this group should not be expected to get back into commercial lending, because prices are inflated and interest rates have gone up. Market volatility has sharply reduced CMBS offerings as well. Insurance companies are stepping in to fill some gaps, and private debt funds are emerging as an alternative space.
Of all the property sectors, only multifamily housing can be said to be near its long-term growth rate for new supply, although the pace is beginning to slow. The office sector is experiencing some marginal supply additions in a handful of markets for the first time in years. In the industrial sector, new and expanded distribution facilities are outpacing expectations and attracting investors, both domestically and internationally.
The retail world continues to reimagine itself, as major department stores (Macy’s, Sears, JCPenney) close and other mall staples (Limited, Abercrombie & Fitch) fade away. The digital environment—the “Amazon effect”—continues to undermine brick-and-mortar retail platforms, particularly in smaller, subregional suburban malls, and some developers and investors are turning to new mixed-use live/work/play venues with entertainment, high-end dining, and digital/showroom retail combinations. The retail sector will continue to evolve for the foreseeable future.
Alternative, niche sectors are beginning to attract investor interest, including student housing and senior housing, among others, and will continue to do so as demographics and economic fundamentals point to increasing demand. Medical-office supply remains at a fraction of its long-term levels due to the long-term uncertainly around the implementation of the Affordable Care Act. Tenants, particularly medical tenants, are traditionally extremely risk averse, and the perceived risk of further regulatory changes will keep most hospitals and doctors on the sidelines of development, reluctant to sign up for new buildings, all the while continuing to expand in existing buildings.
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David Lynn is the author of five books and more than 70 articles on commercial real estate, and is a frequent speaker in the industry. He is the founder and chief executive officer of Everest Investment Advisors.
Peter C. Burley is a leading real estate market and economics research professional recognized for building and managing strategic research platforms and for developing investment strategies for the real estate industry. His work covers national and regional economic, demographic, industry, and property market trends across all property types.