Unearthing Alpha: Where are the Next Opportunities?

By Sanyu Kyeyune

The job market continues to be the most telling gauge of commercial real estate performance, fueling demand for all property types. At 4.3 percent in June, unemployment dropped to its lowest level since May 2007, according to the Bureau of Labor Statistics. As the U.S. nears full employment, signs point to an end to the current cycle, yet debate persists as to how severe the next recession might be.

“The Fed didn’t raise rates until December 2015, which is incredibly late by historical standards,” explained Ryan Severino, JLL’s chief economist. “And we haven’t seen inflation pressure until the last year or so.” A downturn is improbable in the next 12 to 18 months, he added, and when it hits, it will likely be less severe than in previous periods, due to the slow growth that has characterized this elongated recovery.

Chasing yield

Yet as high valuations and low yields have caused investors to consider assuming more risk in the form of non-core assets in relevant locations, they are more carefully underwriting tenant credit quality.

“A lot of the trends we’re seeing on the leasing side are continuations of what we’ve been seeing throughout the recovery,” Severino commented. “Technology-based tenants continue to dominate office-leasing activity, with Class A continuing to outperform B and C. Large e-commerce firms are creating demand for industrial.”

And despite U.S. and European election outcomes mitigating uncertainty, investment activity has slowed. Cushman & Wakefield counted year-to-date U.S. transaction volume through May at $155 billion, down 15 percent year over year.

By and large, investors are continuing to park capital in safe havens around the world, according to PGIM Real Estate’s 2017 Global Outlook, with more than one-third—$166 billion—flowing into income-producing assets in just eight of the top international cities: London, Paris, Hong Kong, Tokyo, New York, Los Angeles, San Francisco and Washington, D.C. It is no coincidence that half of those cities are in the U.S. Despite the U.S. cycle having reached its peak, noted Jahn Brodwin, senior managing director of FTI Consulting, “post-Brexit, the U.S. looks like the best option for inflation protection and currency hedging.”

Though China has been a less active participant in real estate investment, thanks to increased capital restrictions, Australia has rebounded following the global financial crisis, as has the Middle East, with a trend toward opportunistic ventures. “As investors look at places like Dallas or Denver, they’re seeing more interesting options at better prices,” said Bob O’Brien, Deloitte’s global and U.S. real estate and construction sector leader.

Ground-up growth

A slowdown in construction lending has helped regulate real estate performance, according to Severino, moderating supply in most markets along with imposing discipline on the commercial real estate industry as a whole.

Fannie Mae predicts that the supply-demand mismatch in the multifamily sector will last no more than 12 to 24 months, before fundamentals stabilize as demand continues to inch upward. The Moody’s pipeline forecast counts 549,000 units in multifamily starts in 2017 and 521,000 units in 2018.

The industrial sector is benefiting from the growth in e-commerce, with build-to-suit construction up by 29 percent since the fourth quarter of 2016. Combining new deliveries over the past five years and the 247 million square feet to be delivered in 2017, JLL estimates the U.S. industrial market will grow by nearly 1 billion square feet by 2018.

Office development, meanwhile, has shifted toward the suburbs, which can offer higher yields than CBDs. As of the first quarter of 2017, 68 million square feet of office space was underway in the suburbs, compared to 45 million square feet in downtown areas, according to Colliers International.

Niche property sectors that are currently experiencing growth will also continue to offer opportunity as developers race to meet growing demand. Within the medical office subtype, outpatient facilities will feed the development pipeline for the next two years, with 17 million square feet of deliveries on the horizon, estimates research firm Revista. 

Student housing constitutes another opportunity as universities outsource to skilled developers so they can devote more resources to research and academics. As the traditional dormitory becomes a vestige of the past, new, higher-quality product is shoring up investor demand from outside the U.S.

“The next evolution (in student housing) seems to be repositioning the university as a community center, serving multiple demographics for lifelong learning,” said PwC U.S. Real Estate Leader Byron Carlock. The gap between enrollment and supply of purpose-built student housing properties presents a prime opportunity for developers willing to accept more risk. 

The Rewards Landscape

As spreads tighten, investors willing to explore riskier strategies have found rewards in the primary real estate asset types, as well as in specialty sectors.

• Multifamily: More than 400,000 multifamily rental units are expected to come online this year, with an additional 230,000 underway, as compared to the 900,000 units delivered between 2014 and 2016, reported Fannie Mae. However, this new supply is heavily skewed toward the luxury end, leaving a scarcity of available apartments in areas with lower asking rents.
• Industrial: While disrupting the retail sector, e-commerce has caused a spike in tenant demand for state-of-the-art distribution facilities and last-mile fulfillment centers, pushing vacancy rates to their lowest level in 17 years: 5.3 percent overall as of the first quarter of 2017, according to JLL. “The need for additional logistics is going to continue as e-commerce takes a bigger bite out of the retail landscape,” said Jahn Brodwin, senior managing director of FTI Consulting.
• Retail: Retail, Brodwin noted, will reinvent itself. “The lower and upper ends of retail will see the greatest gains.” Currently, there has been a decline in new construction, as more owners focus on reworking vacated anchor spaces and adding experiential tenants to the roster. Resulting from this dynamic, value- and service-oriented retailers are expanding. In all, Marcus & Millichap forecasts 81 million square feet of net absorption in 2017. By staying attuned to the sector’s transformation, retail investors have been able to unlock value in locations with strong demographics, spurred on by fewer competitors vying for these assets.
• Office: Buoyed by technology hubs such as New York, Dallas, San Francisco and Washington, D.C., investment in the office sector has largely become bifurcated between institutional investors targeting core properties and private investors making value-add plays. But with occupancy growth waning and the development pipeline representing just 2.7 percent of total inventory, more investors have broadened their strategies to include niche property types such as health-care real estate.
• Medical Office: Offering a more appealing risk-return profile than mainstream office, the medical office sector continues to lure investment, despite modest growth in supply, due to its typically lower turnover and volatility, said Ken Riggs, president of Situs RERC. Citing a strong finish to 2016, Colliers International measured the sector’s overall vacancy at an all-time low of 7.4 percent and net absorption up 25 percent, as of year-end 2016.

Originally appearing in the Mid-Year Update 2017.