For real estate investors, the U.S. plays a leading role on the world stage. They are attracted by sound real estate fundamentals, the buoyant economy, and appealing investment opportunities across sectors and markets. The economy’s favored safe-haven status is proving to be a boon for the asset class.
Investors will be watching closely how the US economy performs under President Trump’s administration. In December 2016, the Federal Open Market Committee raised rates for just the second time in a decade. With the dollar continuing to strengthen against global currencies, heavy federal spending on infrastructure and defense on the agenda and tax cuts promised, inflation is very likely to rise. The market is anticipating three more interest rate hikes in 2017.
The yield on 10-year U.S. treasuries, at 2.41% in early March, may place pressure on commercial real estate if it continues its upward trend. However, the stable economy and robust outlook for property fundamentals, with spreads at healthy levels compared with the previous peak, provide a positive framework for U.S. real estate investment.
Investors should consider a word of caution, however, about pricing levels, cycle longevity concerns, debt maturities and heightened sensitivity to risk, which have all added to volatility in the real estate capital markets.
“If we continue to see volatility in world sentiment, it translates into a spike in risk premiums,” says Michael Hudgins, managing director and global strategist at EII Capital Management Inc. “This drives up the price of bonds, which can impact transaction volume and, therefore, sentiment regarding real estate values.”
Yield-hungry investors flock to real estate
Federal Reserve Chair Janet Yellen and her colleagues are influenced by global economic volatility in terms of U.S. monetary policy. But with the Fed expected to raise rates in the U.S. this year, it is communicating a clear message that the economy has achieved its milestone post-financial crisis recovery.
Low and negative government bond yields worldwide continue to encourage yield-hungry investors to search for appealing risk-adjusted alternatives. And following a stellar year for U.S. real estate in 2015 and a strong performance in 2016, there is consensus that investors will continue to chase the asset class for these returns.
U.S. real estate investment for 2016 totaled $432.4 billion. This represents negative growth over the period, but 2016 is still the second-strongest year since 2007, according to JLL’s Investment Outlook for Q4 2016
. The multifamily sector stood out over the same period, recording a 4.3% increase in investment from 2015’s record-setting volumes. In the office sector, meanwhile, a flurry of fourth-quarter 2016 deals resulted in a stable year-on-year comparison. The outlook for growth anticipates real estate investment volumes rising by 0–5% in 2017 year on year.
“As long as the economy continues to expand at 2% real GDP and 3% to 3.5% nominal GDP,” says Hudgins, “this is absolutely supportive of continued positive returns for real estate, driven by yield and a modicum of appreciation.”
New market opportunities
Certain U.S. investor groups, including life science companies and some institutional money managers, have been particularly active in real estate markets. But the robust level of demand means that investors increasingly need to look further afield for yield opportunities.
“Many of the prime targets have been bought up and are trading at very high prices,” says Ron Messenger, partner at Grant Thornton LLP. “So institutional money is starting to flow into the secondary and tertiary markets.” These include cities such as Austin, Texas; Dallas, Texas; and Seattle, Washington.
Transactions in the secondary market increased by 4% to reach $113.3 billion in 2016, according to the JLL research. This welcome boost reflects diversifying investment strategies in the multifamily and retail sectors across various high-growth cities.
Non-US investors further boost demand
Nearly all (95%) of the respondents in an Association of Foreign Investors in Real Estate 2017 survey
said they expect to maintain or increase their investment in real estate this year. The top five U.S. cities favored by foreign investors are New York, Los Angeles, Boston, Seattle and San Francisco. Globally, the top five cities are New York, Berlin, London, Los Angeles and San Francisco. Concerns about the Brexit process in the UK have led London to lose its top ranking among foreign investors.
U.S. investors are increasingly contending with strong demand from non-U.S. sources of institutional capital, including sovereign wealth funds and non-U.S. pension funds. Many pension funds, for example, are attracted to the U.S. because of limited yield-generating investment opportunities in Europe, says Messenger.
Legislative changes that allow international investors to increase their holdings in U.S. real estate investment trusts (REITs) from 5% to 10% will also be supportive, according to Donald C. Wood, president and CEO of Federal Realty Investment Trust. “It’s something the industry’s been working on for a long time,” he says.
Public vs. private real estate
The routes to market for real estate investors depend on a range of factors. Some favor private or unlisted real estate, while others prefer public real estate such as REITs.
“The private equity real estate asset class has gone gangbusters over the last year or two,” says Lorraine White, a Tax Services partner at Grant Thornton. “There is less regulation, less expense and the market has really been opening its eyes to the private sector.”
According to research company Preqin, private real estate investment funds worldwide have $227 billion in aggregate capital available to invest in early 2017. While much of that record amount of capital is likely to be invested in the U.S., supply of capital may exceed investable assets. However, Preqin’s research indicates that two-thirds of private real estate investors plan to invest more than they did in 2016, which saw an aggregate total investment of $202 billion across more than 3,100 transactions.
Real estate stock exchange classification
The Global Industry Classification Standard (GICS) sector designation for listed real estate companies — which split from the financial services category in September 2016 — could prove to be a boost for listed U.S. real estate companies, including REITs.
“Every investor or investment manager is going to need to have an opinion on real estate because of the GICS,” says Wood. “It will create more demand and more understanding.” Over time, a larger portion of portfolios will be investing in some aspect of real estate, and this will be “a very positive development for the public REITs,” according to Wood.
Debt maturities — cause for concern?
Conscious of the miscalculations many real estate investors made in the run-up to the global financial crisis, public REITs have made a number of notable dispositions of real estate assets, selling to willing buyers in private real estate.
In an effort to improve portfolio quality, vendors have been motivated to manage their risk and deleverage. For some real estate managers, however, maturing 2006 and 2007 debt could become a headwind if it is not managed properly.
“We’ll certainly be seeing a lot of maturing 10-year collateralized mortgage-backed securities in 2017,” explains Wood. In fact, CBRE Global Investors estimates that $400 billion worth of debt is due to be refinanced in 2017, matching the debt due in 2016 and up from $300 billion in 2015.
Real estate has come of age
Institutional investors’ detailed understanding of real estate is a work in progress, but the asset class has truly come of age.
Real estate represents a core investment allocation that generally accounts for about 10% of institutional investment portfolios, and it has the potential to grow further. “I think we’ll see that 10% increase steadily over the next 10 years or so by maybe four or five percentage points,” says White.