06 Jun 2017

Inside Real Estate - June 2017

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by Indraneel Karlekar, Ph.D., Senior Managing Director, Global Research & Strategy
Table of Contents: 

Key themes

Searching for clarity under a new regime – Six months into a new presidency, the world continues to look to the Trump administration to execute on a host of policy issues promised during the campaign. So far, meaningful progress remains elusive. There is a danger that policy risk could start to negatively impact growth expectations and lead to heightened volatility and growing risk aversion.

Can economic output accelerate? – As the U.S. economy heads towards its second longest post-WWII expansion, the good news is that there are few signs of any catalysts that could cause the economy to downshift, at least in the short-term. In fact, tight labor markets, improving headline inflation data, and strong global growth has created a favorable backdrop for policy reform to potentially lift growth higher over the coming months. Despite a disappointing first quarter, Principal Real Estate Investors believes that under a positive policy environment, the U.S. economy may accelerate to 2% to 2.5% in the second half of 2017.

Fed signals tighter monetary policy – Signaling that the weak first quarter GDP reading was transitory, the Federal Reserve (Fed) has indicated that it will continue with its path of interest rate normalization in a measured manner. The Fed continues to guide investors towards two more interest rate increases in 2017, potentially setting the stage for upward pressure on yields.

Supply side pressures are starting to mount – New supply remains low by historical standards, though there are clear signs that construction pipelines are ramping up and are approaching cyclical peaks. Apartment, office, and industrial should see peak cycle deliveries over the next 12 months, causing modest increases in vacancy rates and slower rent growth.

Overweight to debt, but remain opportunistic in private equity – Core real estate investment performance has slowed meaningfully and has validated the caution we suggested in our 2016 annual report. Given the deceleration expected in rent growth and a slowing pace of appreciation, our broad tilt remains to debt over equity in core real estate strategies. However, investors may continue to find selective opportunities in private real estate strategies that can access markets with high barriers to entry, and still generate attractive opportunities for risk-tolerant investors.

Chapter 1: Searching for clarity in a time of change

Six months after a contentious election that led Donald Trump to the Presidency of the United States on a populist and unconventional platform, global investors and capital markets continue to seek clarity on a broad range of policy issues including tax reform, infrastructure spending, immigration, and government spending. The U.S. economy’s string of poor first quarter GDP prints for the fourth straight year adds to the sense of uncertainty. In terms of hard data, slower economic growth has been attributed to a pullback in consumer spending, perhaps in anticipation of a long and protracted battle over policy between the Republican and Democratic parties.

Indeed, policy uncertainty is the biggest headwind facing the U.S. economy at present. So far, initial policy stumbles have been overlooked in the hope that significant changes over the next six to 12 months will elevate economic activity from the 1.5% to 2.0% rate. In other words, investors are trading on expectations that policy reform will unleash the economy and market’s “animal spirits.” Nevertheless, there are signs of concern over the ability to generate meaningful policy change. This has been most evident in the volatility of the yield curve, which suggests that investors are getting nervous that Congress will not be able to achieve any meaningful legislation in the near-term. While not expecting any miracles, some strides towards a mélange of policy issues will go a long way in providing clarity and direction.

These questions and issues are not merely theoretical because they will likely determine the pace and direction of economic growth over the coming years. The good news is that the Trump Administration has some room to maneuver since key economic indicators are quite good. We expect the weakness of the first quarter to transform into stronger economic activity as the year progresses. What are the catalysts behind this?

Key indicators that have been signaling quite a strong economic environment remain firm. The labor market continues to tighten (average monthly payroll growth of 176,000 in the first quarter) and support the housing market, in turn propelling consumer confidence to higher levels (the pullback in spending in the first quarter is hopefully temporary). In fact, employment with the millennial cohort has been especially strong as shown in exhibit 1.

Another key indicator is the single-family housing market. Over the past 12 months, the Case-Shiller index of home prices is up 5.7% (through March). Average hourly earnings are inching higher and should exceed 3% by the end of 2017. Household formation is also normalizing at around 1.5 million, driven by solid growth in millennial employment, which is a good predictor for continued strength in the housing market. With consumer balance sheets healed and household debt levels generally manageable, the consumption side of the economy, which accounts for about 70% of growth, should continue to provide the heavy lifting necessary to provide a modest boost to the economy over the coming months. However, corporations need to finally start spending for growth to accelerate to the 2.5% range in the second half of 2017.

Additional support to the United States should also come from synchronized growth in the global economy. For the first time since 2010, the global economy is expanding in tandem. Developed markets are benefiting from a resurgent Eurozone, where consumer confidence is at an elevated level. Further, Japan’s growth was recently revised up for the first time in nine years. Emerging markets have also come out of a slump with growing confidence that China will avoid a hard landing at least in the short term. India has embarked on a secular path of growth that will consistently exceed 7% to 8% for the imminent future. Global growth is forecast to hit about 3.8% to 4.0% in the second half of 2017, providing a favorable backdrop of demand for U.S. manufacturing and services.

Chapter 2: Fed guidance suggests optimism on economic outlook

The Fed’s reaffirmation of continued normalization of monetary policy is perhaps the clearest indication that it continues to believe the economic outlook remains positive. Until recently, the Fed’s optimism has not been shared by capital markets. There has been a significant gap between market expectations for interest rates and the Fed’s so called “dot plots” (expectations of short-term interest rates that are published after each FOMC meeting). And for the most part, markets have generally been correct (i.e., the Fed has not followed through on its generally bullish view on interest rate increases). However, thedisconnect on short-term rates seems to have closed a little. According to a Bloomberg survey as of mid-May, there is growing consensus within capital markets that the Fed will follow through on its public suggestion of two more interest rate hikes in 2017 (as shown in exhibit 2).

While capital markets and the Fed may be more in sync on the short end of the yield curve, the disconnect remains quite wide on views around longer term interest rates. If economic growth is expected to stay on course, and even accelerate, the yield curve should be steepening. However, the yield curve has flattened considerably, suggesting that either: (a) markets are discounting an expected acceleration in growth; or (b) inflation pressures are going to be transitory. Of course, the markets could also be misinterpreting the Fed and charting their own view on future economic growth. The apparent dissonance between the Fed and capital markets likely portends the probability of elevated volatility over the coming months.

If the economy does start to pick up pace in the second half of the year as Principal Real Estate Investors expects, the markets should start to price-in a much higher probability for a steeper yieldcurve. In an environment of higher interest rates, volatility can be particularly challenging for the public real estate quadrants, with REITs especially sensitive to interest rate movements. Tighter monetary policy (and presumably a steeper and higher yield curve) will also begin to impact the spread relationship between commercial real estate and 10-year Treasury yields. Until recently, real estate investors were receiving an above-average spread to long-dated Treasury yields, as shown in exhibit 3. With the rise in interest rates (except for April), that spread has reverted to its long-term average indicating that real estate still offers reasonable, though not compelling value versus fixed income. Put another way, investors might start to require additional spread premium over 10-year Treasury yields, which in turn could put some upward pressure on cap rates in some markets and property types.

In an environment of potentially rising rates, the best strategy for real estate investors will be in the form of growing net operating income (NOI) to offset increases in the cost of capital or exit cap rate assumptions. Given the duration of the current economic and real estate cycle, investors should continue with “stock picking” strategies (i.e., be very specific in pursuit of their objectives rather than relying on “beta” to achieve their target return expectations). According to the PREA consensus forecast, the NCREIF NPI is expected to deliver a nominal annual total return of 6.0% over 2017-19, which is 360 basis points (bps) below its long-term average. Income growth and an appropriate cost basis will be the best way to protect against rising interest rates going forward.

Chapter 3: Space market fundamentals

Investors can be heartened by the state of tenant demand. A strong labor market, improved consumer confidence and an expectation for modest improvement in corporate capital expenditures, indicate that pricing power should generally still favor landlords, in turn helping drive NOI growth by varying degrees. An uptick in supply is likely to start wearing on rent growth, but the continuation of relative equilibrium over the next 12 to 18 months suggests that national rent increases in the 2% to 5% range are achievable. The delta in rent growth is likely to vary significantly by property type, location, lease duration etc., which makes a “stock picking” strategy very important for investors looking to outperform a benchmark.

A slow-growth economy and lower expectations for investment returns have placed a premium on well-leased assets, and the still-low vacancy rates in the multi-family sector are a significant attraction for capital. At $153 billion, apartment sales held up well in 2016 relative to other property types, and eked out a small increase over 2015. However, we are starting to see weakness in multi-family transaction volumes as demand starts to weaken and occupancies come under pressure, particularly on the higher end of the market. While supply is the biggest challenge to this property type over the next 12 to 18 months, Class A/luxury apartments are most at risk from over-building and weakening demand as affordability metrics, especially in gateway markets, get stretched.

According to Reis, Inc., the U.S. apartment market has seen new supply deliveries jump from less than 43,000 units in 2011 to more than 210,000 units in 2015. Although deliveries of new units slowed in 2016, the pace of development remained elevated and some of that slowdown was the result of projects being pushed out into later quarters, with a result that  several projects slated to deliver in 2016 will come on line in 2017. This new supply is expected to push apartment inventories up by 2.6% this year, which is a 19-year high. The good news is that the supply boom will likely peak in 2017 as evidenced by data indicating a slowdown in apartment starts and permits, shown in exhibit 4.

Supply headwinds notwithstanding, the demand side of the equation remains strong if somewhat nuanced. For starters, we see a picture of strong current tenant demand driven by favorable economic, demographic and secular trends that point to a continuation of healthy absorption, relatively low vacancy rates and continued rent growth, at least in some subsectors of the market. Calculations using Census Bureau data suggest that the forecasted growth in population and households could lead to a need for about 6.8 million new housing units over the next five years. Using Census Bureau data, the apartment share of this total would be about 31%, or about 2.1 million new apartment units. Even with the record level of new apartment supply in the pipeline, the number of anticipated multi-family units is well short of the amount needed to keep up with prospective demand.

The problem facing the apartment market however, is not necessarily over supply, but a mismatch between the type of new inventory being delivered, and the type most in demand. The bulk of new construction is in Class A or luxury units which have been targeted by developers to make a “reasonable” profit due to high barriers to entry and conservative financing options available in sought-after urban locations. Reis reports that Class A apartment vacancies have risen by more than 100 bps over the last few years, while Class B/C apartment vacancies continue to fall. Economic theory suggests this will inevitably lead to faster Class A effective rent deceleration or even declines.

Moreover, average Class A asking rents are currently more than 40% higher than those for Class B/C units. Current apartment dwellers who are renters by necessity are unlikely to be able to afford Class A apartment units. Younger adults, most notably millennials, are the most likely to become new apartment tenants. Since most of them are just starting their careers and many are saddled with student debt, their disposable incomes are not enough to cover or justify living in new upscale, frequently urban apartment complexes. Thus, higher demand for Class B/C apartment units and a dearth of development of these types of units will mean continued (and maybe accelerating) rent growth for the mid-to-lower priced subsector of the apartment market.

Another factor that is favorable for continued demand in that subsector concerns the substitutability of single-family for multi-family residences. Current renters by necessity and younger apartment dwellers are unlikely to jump into the first-time, single-family owner market due to affordability, still-strict underwriting guidelines, and rising interest rates (exhibit 5). Even over the intermediate term, when millennials begin to marry and start families in greater numbers, it is uncertain that they will be able to afford to purchase homes – even in the less costly suburbs. The challenge facing apartment investors in the short-term thus is not demand per se but of a misalignment of landlord pricing expectations with what the market can currently bear.

Apartments have suffered in terms of investment performance as investors have fretted over (a) very strong pricing metrics and (b) oversupply and the potential drag on rent growth. Investment performance from this property type has been poor, with total returns declining or flat over the past seven quarters. However, the sector’s historically stable income returns, on both an absolute and risk adjusted basis, will highlight the value of this property type especially in an environment of declining NOI growth. Although pricing will remain a key headwind to more robust capital appreciation at this stage in the cycle, particularly as spreads tighten with anticipated increases in long-dated Treasury yields, apartment transaction volumes should stay strong given its defensive characteristics.

Hotel industry fundamentals appear to have peaked in the United States. Although occupancy has been increasing by a marginal level, RevPAR growth has been decelerating: first quarter 2017 national hotel occupancy was flat over the quarter but down 60 bps over the year and is at the highest level recorded in more than 28 years. However, year-overyear RevPAR growth declined to 3.6% in first quarter — the first time this growth rate has been lower than 4% since the last downturn ended. Further, capital market demand appears to have slowed for the hotel sector. Data for first quarter 2017 indicates a meager 2% increase in sales from first quarter 2016 totals. The biggest headwind to improving ADRs and RevPAR is a burgeoning supply of new hotels.

In 2014 and 2015, net additions to the inventory in the national hotel market totaled just 1.2% each year. In 2016, new additions jumped to 1.8%, a volume not seen since 2009. And this metric is expected to increase to 2.7% in 2017. While construction deliveries should decline somewhat in 2018 and 2019, they will still be higher than any year recorded in the post-GFC period.

In March 2017, STR reported there were 1,449 hotel projects with 190,764 rooms under construction in the United States, a 24.4% increase from March 2016 levels. In addition, another 3,272 hotel projects with 380,547 rooms were in the planning phases — a 10% increase from year earlier levels. Rooms currently under construction will increase existing  U.S. hotel stock by 3.7% over the next couple of years; and if all the rooms under construction and in planning are completed, the total inventory of hotel supply will rise by approximately 11%. Some markets are in an even more precarious situation regarding supply with New York, Nashville, Seattle, Denver, and Dallas most at risk (exhibit 7). A possible mitigating factor to increases in supply is the stronger relative economic growth in these markets, as evidenced by Gross Metro Product (GMP), which is thought to be the best indicator of hotel demand.

Unlike the surge in construction, demand is expected to stay flat over the next several quarters or perhaps even slow as the labor market reaches full employment. If the dollar strengthens (with further Fed tightening), it will create an additional headwind for offshore visitors. The impact of policy decisions by the new administration could also influence hotel demand. One possibility could be that policy initiatives spur economic growth and corporate profits. This would benefit business travel and thus hotel demand. On the other side of the coin, tourism to the United States may slow because of travel bans and negative perceptions of the United States abroad.

Outstanding RevPAR growth over the last few years is not the only reason that hotel developers have become more active, hotels also performed well in the capital markets until very recently. As measured by Real Capital Analytics, data for sales of hotel properties ($5 million or greater) in 2016 indicate that hotel sales totaled $39.5 billion in 2016, a decline of 22% over the total for 2015. However, the average price per room increased by 13.5%. Data for first quarter 2017, reinforces the slowing trend. Through March 31, 2017, the total volume of hotel sales in the United States was only $6.5 billion, representing a meager 2% increase from the same 2016 period; price per unit increased by 9% to $163,100, however. Hotel transaction volume is likely to stay under pressure until supply eases and demand strengthens (see exhibit 8).

The industrial sector remains in the sweet spot of tenant demand. Slow but sustained economic growth has led to an uptick in homebuilding, a steady and expanding manufacturing sector, and growing retail sales, including e-commerce. As a result of these factors, industrial availability rates continue to fall, although the flipside of such strong demand (pushing annual rent growth to the mid-single digits), is a wave of new development that typically accompanies longer cycles. In fact, the largest challenge facing the industrial market may be acceleration in construction activity. To date, the industrial supply cycle has been kind to landlords as development activity has tracked near historical lows since the recovery started, but that is starting to change.

Peak occupancy, rising rents and increasing property values have encouraged developers and speculative construction is starting to increase. Industrial space under construction is now roughly 1.4% of total inventory, which is in line with its 28-year historical average. Nascent upward pressure on industrial availability rates notwithstanding, there is little evidence that landlords are yielding much if any pricing power, as most markets remain at or below equilibrium. Moreover, the bulk of new supply is comprised of large modern warehouse space that has been in short supply through much of the cycle. E-commerce related demand by third-party logistics providers and healthy leasing from other logistics and distribution tenants continue to fuel positive rent growth. We view the supply cycle as a longer-term phenomenon for the industrial market amid elevated consumer confidence and spending and continued gains in e-commerce and omni-channel delivery systems. Upward pressure — to the extent that it has a meaningful impact on markets — will prove uneven regionally. All 15 markets with the highest forecasted availability increases over the next 12 months are still expected to post positive rental growth, as the new deliveries are needed to satisfy pent-up demand (see exhibit 9).

Rent growth for the national industrial market is expected to continue to be the strongest out of the four main property types, as drivers in industrial demand remain steady. Just as we have noted that markets with increased availability are still experiencing positive rental growth, we expect the same to be true for the overall national industrial sector. Confirming the overall trend of pent-up industrial demand nationally, we are forecasting robust national industrial rent growth of 5% to 6%, despite modest increases in availability in 2017. Gains are likely to taper off as the supply cycle peaks, but will settle into more modest growth over the longer-term forecast.

Demand for logistics and warehouse assets continue to benefit from the small resurgence in U.S. manufacturing, a healthy housing market, and a re-configuration of the North American supply chain to accommodate e-commerce retailers and consumers. Although the manufacturing sector remains a smaller part of the industrial demand equation than it did decades ago, since 2010 we have seen the longest and most persistent period of growth in goods-producing payroll employment. It is estimated that roughly 400,000 jobs have been “re-shored” between 2010 and 2016, generating a total of 1.2 million new support jobs through the multiplier effect.1

Perhaps more important from a long-term demand perspective are the continued effects of online shopping that have now spread beyond traditional brick and mortar formats to threaten grocery stores and other neighborhood and community tenants—once considered the bedrock of retail demand.

Despite comprising just 8.3% of retail activity, e-commerce sales increased by 12% over the past 12 months. The National Association of Office and Industrial Properties (NAOIP) estimates that by 2020 the United States will sell $486 billion of goods to the world in crossborder e-commerce, while the United States will buy $140 billion of goods from overseas in cross border e-commerce. NAOIP also estimates this activity will require over 100 new large e-commerce logistics centers, as well as another 100 new or re-purposed smaller facilities to support local delivery. The sustained expansion of e-commerce will continue to positively impact industrial assets from big-box logistics facilities to last-mile distribution centers. Urban infill locations areas are also primary beneficiaries as retailers continue to seek efficiency, particularly for the last-mile of the logistics chain.

The primary risks to the industrial sector remain its susceptibility to the global economy amid geopolitical instability and a wave of nationalist and protectionist populism in developed nations. In the United States this is manifest in the protectionist policies vowed by the Trump administration. Though the effectiveness of the administration in implementing policy remains in question, the potential for tariffs, a border-adjustment tax, and the renegotiation of trade deals such as NAFTA all present risks for the industrial market. A full implementation of such a Trump agenda could negatively affect trade and possibly be very disruptive to U.S. supply chains, which would in turn hurt U.S. manufacturing production, and ultimately, demand for industrial space.

From an investment standpoint, industrial is feeling the same impact of capital markets uncertainty as the other major property types, despite healthy space market fundamentals. The prospect of increased interest rates and investor uncertainty over the longevity of the cycle has caused transaction volume to cool. Although from a capital market perspective industrial appears to have pumped the brakes, it seems to be more out of investor uncertainty than outright concern over the current expansion. Investors are seeking clarity in a sector that continues to exhibit a great deal of upside potential, but faces possible headwinds from changing trade policies and global ambiguity. The transformation of the industrial sector from one dominated by traditional warehouses into a market characterized by modern logistics hubs in the burgeoning e-commerce economy has attracted a great deal of capital. This has pushed NCREIF industrial cap rates to roughly 5%, as shown in exhibit 10. Despite lower yields, spreads have remained wide relative to the other major property types and have been an important driver of capital to the industrial sector.

Factors to watch over the next 12 to 24 months will be new supply causing an uptick in availability rates and the potential impact on rent growth. Investment activity and values are expected to remain healthy over the next couple of years as investors seek quality and stability. U.S. industrial assets will continue to attract capital looking for a place to park in this unpredictable, late-cycle climate. Thus, despite the uncertainty of trade policies, protectionism, inflation and interest rates, we believe that the near-term outlook for continued growth in the U.S. economy, paired with long-term structural changes in the sector, favor the industrial market over the outlook period.

The office sector is one of the more cyclical property types. Though fundamentally sound with relatively low vacancy, respectable demand and continued rent growth, the sector is signaling that improvements in space market fundamentals will be more modest for the balance of 2017. Office leasing velocity has slowed in many markets and a recent uptick in new supply is pointing to softer occupancy improvements despite relatively robust hiring among white collar employers. Occupiers have remained somewhat restrained through the cycle and are showing signs that they are wary of taking space at the top of the market in the latter stages of an economic expansion, which at this point next year will be the second longest on record since World War II.

The late-cycle slowdown in office leasing is somewhat understandable given the relatively slow pace of economic growth and the shadow cast by the last two recessions, which were both severe for office investors from a space markets perspective. Leading up to the dot.com bust and  the global financial crisis, strong economic growth and rapidly rising rents pushed tenants to take on space before it was needed as the carry cost was lower than predicted rent levels, particularly in gateway and high-tech markets. As a result, occupiers are adopting a more prudent approach in handling their leasing requirements.

It also appears that corporate occupiers are adopting a wait-and-see attitude as we round the corner toward the second half of the new administration’s first year. Although business and consumer sentiment remain elevated on campaign promises of tax reform, stimulus spending, and increased job growth—all of which should bolster domestic growth—questions remain about the political will to follow through on these proposals. The office market, with its high correlation to economic cycles, may be the most at risk from a demand and income perspective should policy failures impact business spending and hiring.

Aside from cycle and policy risks, the office market has not seen the robust pace of demand or vacancy declines it experienced in prior expansions. Though the severity of the last recession is certainly a credible reason for the slow pace of occupancy growth early in the current cycle, structural changes to the office market are also having a measurable impact. Increased efficiency with which organizations aspire to use space has played a key role in reducing the amount of square footage needed during the recovery. Smaller space requirements are nothing new, in fact during each of the last three expansions (dating back to the late 1980s) the amount of demanded space per worker has declined despite office payrolls reaching new highs. As indicated in exhibit 11, office demand just isn’t what it used to be.

Although increased use of technology, more functional office design and alternative working arrangements will continue to conspire to place downward pressure on the amount of space that firms may need, demand for office space is certainly not doomed over the longer run or even over the balance of the current cycle. Office-using industries continue to add workers at a steady pace, roughly 2.3% on a year-over-year basis, which is more than enough to  keep demand positive over the next year and beyond, barring an economic downturn. That said, prospects for demand improvements remain uneven with clear favorites continuing to be high-tech hubs like Austin, San Jose, and Seattle, while larger gateway markets like Chicago, New York, and Washington DC continue to struggle at this stage in the cycle.

On the supply side of the market, there has been little change over the past few months. Supply pipelines, though far from bloated, are slated to deliver more square footage in 2017 than at any point in the past decade. It is expected that this year will see roughly 65 million sf of new office space delivered to the market, an increase in office stock of roughly 1.6%. Although the increase in new supply will certainly challenge metro areas where demand has weakened in recent months, supply is largely focused in a relative small number of markets. As an example, San Jose alone accounts for more than 15% of all new supply expected in the United States this year, followed by Dallas at just over 12%, as shown in exhibit 12.

While San Jose is perhaps best positioned to handle the glut of new space slated to hit the market in the next several months (with current office payrolls at an astounding 30% above pre-GFC levels), others will clearly struggle to maintain current vacancy rates. Despite high levels of pre-leasing for core office buildings slated to hit the market, these new deliveries will likely pull demand from older, existing inventory in the market, rather than relying on purely organic demand growth.

Our outlook for the office market while not stellar, remains solid and in line with current growth expectations. Vacancy rates remain in equilibrium, but increased supply is starting to erode landlord pricing power and with it the ability to effectively push for higher rents on new leases. As an example, annual rent growth, according to CBRE EA, clocked in at just 1.3% in 2016. While we view this as somewhat of an anomaly, our own rent growth expectations are more subdued and in line with broader inflation at 2.0% to 2.5% over the next two years.

Overall, there is no single red flag that suggests the office market is heading for trouble; rather it is a confluence of late cycle supply and the prospect of slower office demand that present some cause for concern. This reinforces our view that core office, particularly in gateway cities, will be increasingly difficult to navigate if investors are looking to obtain excess return on investment. For the most part, we continue to see appreciation on a downward glide path with investors relying on income growth strategies based on markets and assets that can generate consistent returns in the late stages of the expansion.

The retail property sector, despite facing secular headwinds that will continue to raise questions over its long-term growth prospects, continues to capitalize on the economic expansion mirroring its slow but steady progress. Occupancy improvements and demand have remained slow during the cycle, but largely in line with restrained development activity in most markets. Income growth as measured by rent remains intact, but subdued, averaging just less than 2% over the past 12 months. Granted we do not anticipate blockbuster performance for the retail sector, our view is not all gloom and doom.

Since the last recession, limited construction in all center types has helped push vacancies lower with malls leading the way, followed by power centers. Neighborhood and community center vacancies remained unchanged at 9.9% in the first quarter of 2017, but in the past five years, demand continuously outpaced supply in a show of developer discipline that allowed rents to grow, albeit at lower rates. Properties located in affluent urban neighborhood with limited competition and spatial constraints that limit additional supply remain more attractive to tenants and investors alike. Several properties in Nevada and California for example sold for thousands of dollars per square foot at cap rates well below 5%.

News headlines related to store closures more recently have added scrutiny to the retail overall sector. Whereas the United States is undergoing significant change in the retail landscape with the readjustment of pre-GFC oversupply, most of the closings have been concentrated in low performing malls and affected tenants operating in a saturated retail market while facing evolving consumer demands their current format is ill-equipped to fulfill.

Oversized retail footprints are no longer necessary to sustain profitable sales and in many cases have become burdensome for tenants to maintain from a cost perspective. Sales for non-store retailers, which were lower than those of clothing stores in 2000, are now double the latter’s sales estimates. In fact, non-store retailers, who own the biggest share of e-commerce sales at 87%, now account for over 47% of GAFO (merchandise normally sold in department stores) sales — perhaps highlighting a shift in consumers’ increased demand for convenience.

Although e-commerce as a percent of total retail sales remains relatively small (currently at 8.3%), it continues to grow, with some estimates putting it as high as 30% of GAFO sales. Amazon’s heavy investment in its distribution network and its transportation ambitions, along with the M&A binge from other dominant retailers such as Walmart and Walgreens Boots, suggest dire times ahead for weaker retailers who are not aggressively meeting tailored consumer expectations through the implementation of robust omni-channel strategy.

Consider for example the stability of grocery-anchored retail centers (generally preferred by institutional investors), which are in stark contrast to the department stores dominating the news cycle with store closings. As shown in exhibit 13, grocery stores and restaurants have continuously generated positive sales growth since 2000. Given that department store sales have declined in 14 of the last 17 years, it is evident that an irreversible shift has already occurred in consumer behavior and that those playing in the field need to either adapt or will be phased out as the secular trend continues.

However, it is not all gloom and doom for retailers. Half of announced closings so far this year are in malls, which account for only 10% of US retail stock. Class B and C malls account for almost 90% of those malls. In many cases, previously closed shopping centers have been redeveloped. As mentioned in our previous edition, General Growth Properties has spent close to $1.5 billion to redevelop 82 vacant department stores since 2011, generating an 11% average annual return.

Moreover, much of the pain has been felt among the nation’s older and lower quality malls. In fact, Class A malls continue to enjoy some pricing powers in setting rents and new entertainment-filled concepts (like Dave & Buster’s) are being added to shopping centers everywhere to increase foot traffic.

Neighborhood and community centers with grocery stores, restaurants, service-related retail and, as of late, medical facilities as core tenants should continue to provide greater diversity and less volatility in rent growth for the next couple of years. The demand for space for food- and entertainment-related venues are not without risk however. In 2016, the price of food at home fell on an annual basis for the first time in almost 50 years. Consequently for most Americans, it is far cheaper to eat at home than it is to eat out. Some restaurant owners are finding it hard to compete because of the low unemployment rate, which makes it harder to retain labor, and the increased number of new entrants into the restaurant industry over the last couple of years. Further, deflationary pressures on food prices have favored discount stores that are now competing directly with traditional grocery stores.

The retail sector in general also faces additional policy uncertainties from Washington DC as talks of a border adjustment tax and affordable care persist. However, the administration’s recent tax proposal to double the standard deduction could be a bright spot for consumers’ purchasing power. The sector remains attractive with muted supply that should provide restrained but rising rent growth over the forecast period. Retail cap rates through the first half of 2017 continued to compress relative to year-ago levels, which is proof that investors continue to value well-located, high-quality retail assets for their ability to produce stable income returns. As older millennials move to the suburbs to start their families, more opportunities should open for select secondary markets offering urban-like amenities. This could take five to 10 years, however. In the meantime, select areas in markets such as Tampa and Austin, where demographics continue to favor more robust growth should provide investors solid returns.

Four quadrant strategy recommendations

Economic base case: cyclical ~ 2%-2.5% real GDP growth (55% probability)

Under the base case, Principal Real Estate Investors expects some progress in policy reform, combined with higher household and corporate spending, to push economic output higher in the second half of 2017. A healthy job market should also support housing and push wages higher to around 3.5% in the second half of 2017. The global cyclical uptrend is expected to persist into 2018 and should continue to provide a constructive environment for U.S. companies. With underlying fundamentals quite strong, the Fed should be able to raises short-term interest rates two more times in 2017.

Four quadrant real estate strategy recommendations

The forecast for core real estate equity returns to decelerate to below long term averages (per the first quarter 2017 PREA Consensus Forecast) keeps our base case four-quadrant strategy tilted modestly towards debt. In recognition of decelerating but still positive real estate fundamentals, our preferred over-weights include subordinate debt (particularly in non-gateway markets with reasonable value), new issuance CMBS (with a high-quality bias) and select “build to core” and “lease to core” private equity real estate strategies, especially in the student housing, industrial and Class B+ multifamily apartment segments. By property type, we continue to recommend an underweight to the office sector and a modest tilt towards the industrial sector. We also maintain our recommendation of moving towards a higher weighting to selective multi-family and retail, particularly properties with defensively-positioned “necessity” retail tenants.

Over-weight: A bias towards debt leads to an overweight to subordinate debt and select new issue CMBS. Very selective private equity value-add/opportunistic real estate (student housing/ Class B+ multifamily and industrial build to core).  The following is a summary of the investment themes for the four quadrants of U.S. commercial real estate under the base case economic scenario.

Public equity (U.S. REITs)/modest under-weight — modest discount to NAV offset by higher volatility and steeper yield curve. Selective entry points could generate attractive returns

  • Modest under-weight at current values (MSCI at ~1,140, but “fair value” at 1,075 to 1,100) since U.S. REITs remain sensitive to nominal and real interest rate increases as well as slowing FFO growth. Selectively accumulate if prices correct towards MSCI at 1,075 to 1,100 (or lower--attractive) if base case remains intact.
  • Share prices trading roughly at a 7% discount to NAV (based on MSCI at 1,040), but likely to be volatile as prices fully reflect continued economic growth albeit accompanied by low interest rates over an extended time frame.

Public debt (CMBS)/neutral to modest over-weight — regulatory/risk retention rules may influence pricing/volatility; upgrade to higher quality “BBB-/A-” centric bonds

  • Select tranches (new issue “BBB-/A-” bonds) [upgrading quality] that offer attractive yield to maturity relative to core equity/REITs (and pricing reflects a potential for weakness in collateral values/core return).

Private Debt (Mortgages)/modest over-weight — A flat yield curve, compressed risk premium and lower transaction volume may weigh on the opportunity set in the near term, but potential asset-level volatility is a longer-term catalyst.

  • Leveraged loans (engineered subordinate debt) in non-gateway markets should benefit as new risk-based regulations inhibit balance sheet lenders, resulting in a potential for excess risk-adjusted return.
  • Moderating asset level/core returns provide an incentive to leverage up.
  • A flat mortgage credit curve (for higher quality) may weigh on the opportunity set in the near term, but may benefit from the potential for volatility (and a steeper mortgage credit curve) over the intermediate term.

Private equity/neutral-to-modest under-weight — core and levered core returns continue to moderate although opportunities exist through market/asset selection

  • Selective opportunities exist for “build to core” and “lease to core” strategies (through market/asset selection), but there is an increasingly limited opportunity set given the potential for excess supply, especially in office and apartment sectors.
  • Market and property type selection will be increasingly important in driving relative performance.
  • REIT prices (still trading at a discount to NAV) and higher Treasury yields/wider spreads (as Fed is expected to remain active “regardless” of near term economic performance). Prospects for Fed action have increased and may lead to continued moderation in asset appreciation trends for real estate equity.

Economic downside case: Real GDP growth declines to ~1.50%-1.75% (35% probability)

Under an economic downside scenario, the reflation trend turns into a correction. The stock market drops 15% to 20%, a big move but not enough to signal recession. Oil returns to the $25-$35 range and high yield credit spreads widen. The Fed hikes rates in June and perhaps September, but then stops as global financial conditions become a risk again. The U.S. 10- year Treasury reverts to the 1.5% to 1.75% range; the yield curve flattens. The ECB and Bank of Japan keep up their asset purchase programs. Low rates keep this new normal growth going for some time.

Four quadrant real estate strategy recommendations

A slowdown in growth is likely to translate into concerns about softening tenant demand and slowing rent growth. Investors will switch to a capital preservation mode and will require higher risk premia (higher spreads to 10-year Treasury yields), potentially putting upward pressure on cap rates for some markets and property types. Were such a scenario to unfold, we recommend an overweight to multi-family (which may continue to benefit from weakness in the single-family housing market) and essential (grocery-anchored) retail, along with industrial in markets with high barriers to entry.

Overweight: Higher quality private and public debt. The following is a summary of the investment themes for the four quadrants of U.S. commercial real estate under the downside case economic scenario:

Public equity (U.S. REITs)/under-weight

  •  Value-to-replacement cost premium will begin to weigh on total return.
  • Investors factor-in slowing FFO growth, but that may be only partly offset by low interest/refinancing rates (as risk premiums are likely to widen).
  • Higher volatility may weigh on risk-adjusted returns.

Public debt (CMBS)/over-weight

  • New issue (say, “A-” credit quality) CMBS is likely to perform well given attractive credit risk premiums, lower Treasury rates and adequate equity support

Private debt (mortgages)/over-weight

  • Investors will seek safety in senior debt tranches pushing spreads tighter.
  • Lower interest rates should support spread/margins to debt investors.
  • Dollar cost average into (both major and non-major market) subordinate debt with a higher quality bias (since the opportunity set is likely to expand—as the credit curve is likely to steepen).

Private equity/under-weight

  • Value premiums over replacement cost will begin to weigh on total return.
  • Levered core on a select basis (i.e., with limited near term lease rollover/ high quality tenancy) is likely to remain attractive as investors seek safety in gateway markets/core properties (especially for investors with a long-term investment horizon).
  • Value add and opportunistic strategies are likely to underperform as lease-up strategies become more challenging to execute.
  • Debt mark-to-market is likely to be a negative for borrowers who have fixed rate mortgages with long duration.

Economic upside case: 3%+ Real GDP Growth (10% Probability)

A shift to the upside would be engendered by significant tax and regulatory reform which, though currently distant, could appear. Profits are already rebounding significantly in the United States, the Eurozone, China, and Japan. If an acceleration in wages happens soon, investment in productivity-enhancing equipment and software could stage a real surge. Also, little drag from lousy trade policy is likely to occur given the overall change in words and tone in the Trump administration from the campaign. If political uncertainty fades a bit, this combination could result in a significant pickup in GDP (i.e., a cyclical, probably short-lived boom). This is the basis for a considerable upside surprise. The Fed will likely accommodate this and allow growth to overshoot a little, while keeping a gradual pace of rate hikes. 10-year U.S. Treasury yields do hit 3.5% or more but, the fast-paced economy handles that well initially.

Four quadrant real estate strategy recommendations

In an economic upside scenario, we would modestly tilt a neutral portfolio towards equity as a proxy for growth, albeit in a very selective manner since investors may not necessarily have a greater appetite for risk. Within equity, we would recommend exposure to non-core, high-quality markets and favor build to core strategies in Class B+ apartments and the industrial sector.

Over-weight: private equity real estate opportunistic investments plus select CMBS. The following is a summary of the investment themes for the four quadrants of U.S. commercial real estate under the upside economic scenario.

Public equity (U.S. REITs)/neutral (based on MSCI at 1,140 — a 7% discount to NAV)

  • The stronger growth outlook is unlikely to alter market expectations of a quicker than anticipated normalization of monetary policy, but public equity is likely to perform better than core private equity, given the current discount to NAV and better access to capital markets.
  • The development pipeline (and modestly higher leverage) could drive multiples higher.

Public debt (CMBS)/over-weight

  • New issue bonds (“BBB-/BB”) are priced for recession or material deterioration in collateral values—spread tightening is likely to offset higher Treasury rates.

Private Debt (Mortgages)/neutral

  • High-quality mortgages are of limited interest from a total return perspective, but of interest to ALM investors (given excess spread over corporate bonds). Subordinate debt in non-major markets should deliver strong performance (as collateral values improve).
  • In general, high-yield debt has the potential to outperform core/levered core equity but currently is priced for fairly benign credit conditions, which limits the opportunity set.

Private equity/neutral-to-modest under-weight

  • Core/Levered Core may underperform given the premium-to-replacement cost (as supply risks increase) and steeper yield curve (higher cap rates).
  • Select opportunistic strategies (with material pre-leasing in place, student housing and select build to core in Class B+ apartments and industrial) are likely to be attractive and outperform as healthy risk premia offset upward pressure on exit cap rates.



1Harold L. Sirkin, Justin Rose, and Rahul Choraria. “Honing U.S. Manufacturing’s Competitive Edge.” The Boston Consulting Group, January 2017.


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REIT securities are subject to risk factors associated with the real estate industry and tax factors of REIT registration.

Fixed-income investment options that invest in mortgage securities, such as commercial mortgage-backed securities, are subject to increased risk due to real estate exposure.

Investing involves risk, including loss of principal.

Potential investors should be aware of the many risks inherent to owning and investing in real estate, including: adverse general and local economic conditions that can depress the value of the real estate, capital market pricing volatility, declining rental and occupancy rates, value fluctuations, lack of liquidity or illiquidity, leverage, development and lease-up risk, tenant credit issues, circumstances that can interfere with cash flows from particular commercial properties such as extended vacancies, increases in property taxes and operating expenses and casualty or condemnation losses to the real estate, and changes in zoning laws and other governmental rules, physical and environmental conditions, local, state or national regulatory requirements, and increasing property expenses, all of which can lead to a decline in the value of the real estate, a decline in the income produced by the real estate, and declines in the value or total loss in value of securities derived from investments in real estate.

Direct investments in real estate are highly illiquid and subject to industry or economic cycles resulting in downturns in demand.

Accordingly, there can be no assurance that investments in real estate will be able to be sold in a timely manner and/or on favorable terms.

As a general matter, the strategy entails a high degree of risk and is suitable only for investors for whom such an investment is not a complete investment program and who fully understand and is capable of bearing the risks associated with such strategy.

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