Favourable headwinds pick up
Each year, AFIRE members Principal Real Estate Investors, Real Estate Research Corporation and Torto Wheaton Research publish an “Expectations & Market Realities” report. This year’s survey looks at the recent movements in the US real estate market and what can be expected in the short to medium term.
The report notes that the market has been driven by capital market factors, such as low interest rates and volatile stock and corporate bond markets. Today, real estate continues to attract very significant amounts of capital, as secular forces persist. Among these are “demographically-driven investor demand for income and value stability, a permanent role for real estate in institutional asset allocation models, improved real estate debt market risk management, increased global capital market flows to US real estate, and increased ease of investor access to real estate”.
Yet there are emerging signs of cyclical changes in the real estate space and capital markets. Space market fundamentals have bottomed and have begun to recover in most property types and markets. Renewed employment growth and signs of emerging inflation also have led to increasing short-term interest rates and a flattening yield curve.
As a result, the report says: “The headwinds facing space markets and the tailwinds propelling capital markets have started to shift, with space market uncertainties beginning to decrease and capital market uncertainties (particularly capital market pricing drivers, including interest rates and inflation risks) beginning to increase.”
After declining sharply during the past two years, yields for most property types and in most markets are reaching a point of resistance to further declines, given narrowed margins over risk-free rates. However, there are only limited signs of upward pressure on yields at the moment.
Real estate investment activity remains very strong, with deals and pricing highly competitive. The institutional investor market is still the driver, but the retail investor market is growing rapidly, with a proliferation of investment vehicles available to the small investor.
The US economy is moving from a strong recovery phase to a steady and sustainable growth phase, says the report. While business spending remains strong, the likelihood of a deceleration in federal government expenditure and consumer spending growth rates point to more moderate economic growth.
The reports warns that there might be a risk if the surge in oil prices above the $50 (E37)per barrel level is sustained and begins to affect consumer spending.
The US demographic outlook is quite strong compared with other large developed economies, due to immigration and net fertility rates. The US population is growing at a net rate of approximately 25-30m/decade, which will generate significant absolute job growth and absolute demand for all real estate property types over the long term.
Torto Wheaton Research forecasts 10-year total returns for the overall real estate market to range from 7.5-9% or about 300-400 basis points lower than over the past decade. For future returns to equal past returns, real estate would need to make up for lower current yields with higher future appreciation.
However, the report considers this unlikely given the projections for a “measured” but not spectacular economic recovery, structural space market forces that will reduce the trajectory of the short-term space market recovery, capitalisation rates with limited room for further compression, and high current prices relative to reproduction costs.
The report is tipping grocery-anchored retail property to be the best performing sub-sector of the real estate market over the next 10 years. It says this will be due to rental upside that will be captured as retail leases roll over and are re-priced.
The apartment and office sectors are in a close race for second place in terms of future returns, with office returns primarily driven by a rebound in rental levels in the latter part of the next 10 years.
Total returns for industrial properties are expected to lag slightly behind other property types due to new construction and technology-driven shifts in user demand.
The report reckons that, even with lower return expectations in the future, volatility will also be lower than in the past, due to an increase in the size of the listed real estate sector and the increased market discipline it demands and continuing investor appetite, which will reduce the risk of falling capital values.
The office sector presents a unique investment challenge. Demand fundamentals are beginning to improve, and tenant credit quality is generally on the rise. New supply is restrained in most markets.
However, both job growth and the office recovery will be uneven over the short term due to productivity gains and continuing discrepancies in the economic health of various industries, businesses and geographies. Prices and values continue to be driven up by the capital markets, despite weak occupancy and cash flows.
Although declines in office values during the current downward cycle have been much less severe than in the past, office continues to be one of the most volatile property types. Despite these short- to medium-term challenges, the long-term prospects for office demand remain good.
Residential continues to face pressure from cyclical market factors, including continued high levels of new construction, but have generated strong total returns, as residential yields has compressed to an all-time low. New construction continues to be driven primarily by capital market investor demand, but short-term demand fundamentals are improving due to stronger job and household formation growth and the reduction in home affordability due to high housing prices and increased interest rates.
In addition, long-term residential demand fundamentals look excellent, given the demographic situation. However, there are indications that these positive long-term factors may already be fully priced into valuations in many markets. As such, finding good relative value requires careful selection of properties, markets, and sub-markets, with particularly close attention paid to prices relative to rebuilding costs.
Demand fundamentals are beginning to improve, as the US and global economies continue to grow and industrial-using employment improves. However, increases in logistics and distribution productivity will challenge the trajectory of near-term demand recovery, and even contribute to new construction as certain users seek larger, more efficient facilities despite relatively high vacancies in existing properties.
The combination of continued user consolidation, gains in logistics productivity and increases in global trade, will tend to favour larger properties in primary markets, especially those markets that play an important role in the execution of global trade and those with supply constraints.
From a long-term perspective, the outlook for industrial still is quite favourable, as US population growth and the global trade continue to grow, meaning that an ever-increasing absolute volume of products will flow through the US logistics system.
Retail properties brought in total returns of nearly 23% in 2004, as measured by NCREIF. However, this level of performance is clearly unsustainable, due to a combination of limited room for further yield compression, high pricing relative to rebuilding costs, the bond-like nature of retail leases, and a likely reduced trajectory in consumer spending over the next few years.
Nevertheless, we expect that retail returns will be attractive in both an absolute and risk-adjusted sense over both the short and long term, given strong space market fundamentals.
From an investment perspective, retail centres in high population density or high population growth areas are attractive.
Retail centres that offer elements of convenience are also attractive, as a growing and more geographically concentrated US population, and a road infrastructure that can’t keep pace with such growth, lead to increases in traffic
The hotel market is still dealing with the demand problems brought about by the terrorist attacks of 11 September 2001. The hotel market has brought up the rear with respect to risk-adjusted returns, but now has clearly started to rebound from one of its worst downturns.
Given current valuation levels and recovery prospects under the most likely economic outlook, the hotel sector is poised to generate solid risk-adjusted returns relative to other property sectors. Recent positive developments in the hotel sector are increasingly attracting investor capital.
Given still relatively low prices and the strong income growth potential in the hotel sector, we expect hotels to generate double-digit total returns in the years ahead.
Principal Real Estate Investors, Real Estate Research Corporation and Torto Wheaton Research’s sector expectations