US Commercial Real Estate Outlook

Private Markets | March 06, 2018

Real Estate Team

2017 Healthy, 2018 Looking Good

GDP in the third quarter of 2017 remained healthy, increasing at a 3.3% quarterly annualized rate, and more recent economic data generally imply continued strength.1 Some of the improvement was due to hurricane-related distortions (vehicle sales, housing activity, and manufacturing all increased markedly), but underlying those distortions was evidence of more broad-based acceleration. While housing has been boosted by weather-related events, housing market fundamentals are healthy and we expect continued growth in the sector. Consumption remains consistently positive, with recent data showing evidence of healthy growth. At this stage, leading indicators of industrial production broadly point to acceleration over the course of 2018, which in turn bodes well for S&P 500 earnings growth. The labor market continues to add jobs, however wage growth has remained subdued and not contributed to inflation.

Our long-term outlook remains stable: we continue to expect the US economy will grow at moderate rates over our fiveyear forecast period, and do not see a recession as imminent; the low inflation environment is expected to persist. We expect that the new tax bill could add between 0.2% - 3% to GDP growth over the next couple of years, but this could prove to be a conservative estimate if a meaningful increase in business investment were to materialize.

At this stage, we expect continued monetary policy stability. The labor market continues to improve and there is little evidence of inflationary concerns on the horizon. Consequently, the Fed remains in the comfortable position of being able to remove stimulus without being compelled to do so, allowing for minimal disruption to the financial markets. There is one caveat: there will be significant turnover in the Federal Open Market Committee (FOMC) over the next few months, which could lead to some shift in the current philosophy.

Exhibit 1- Retail Sales

Exhibit 1- Retail Sales Chart
Source: Bloomberg, as of December 31, 2017.

REAL ESTATE MARKET OUTLOOK, Q4 2017

Investment Markets

Transaction volumes continued to decline in 2017 for second year in a row, with the total value of deals for Office, Industrial, Retail, and Apartment decreasing by 13% yearover- year in 2017. All asset types experienced slower market activity, except Industrial, which increased by 8% (Exhibit 2). The slowdown in activity was in both domestic and foreign investment which declined by 13% and 19% respectively.2

However, despite slowdown in volumes, prices continue to grow. Apartment, Industrial, Office, and Retail average prices were up year-over-year by 10.2%, 9.8%, 4.1%, and 3.7% respectively (Exhibit 3). Strong market fundamentals, competitive yield spread, and foreign investment are among the main drivers of the price appreciation, which we believe will continue through 2018.

Overall transaction cap rates in 2017 were at 6.2%, down by 7 basis points relative to 2016. Industrial and Apartment enjoyed the strongest cap rate contraction of 35 and 13 basis points reaching 6.5% and 5.6% respectively, while cap rates for Office and Retail ended up flat to slightly above relative to last year, at 6.6% and 6.5% respectively.

Debt markets remained conservative throughout 2017 with average market Loan to Value (LTV) near 60% and mortgage rate spreads to the 10-year Treasury bond yield of above 2.0%. This contrasts with 2007,when average LTV reached above 70% and mortgage spreads stood below 1.0%. We expect the rise in Treasury yields over the next few years to be partly absorbed in the spread, and mortgage rates remain competitive.

Exhibit 2- Transaction Volume, trailing 4Qtr

Exhibit 2- Transaction Volume, trailing 4Qtr Chart
Source: Real Capital Analytics, Manulife Asset Management, as of December 31, 2017.

Exhibit 3- RCA Commercial Property Price Index (CPPI) YoY change as of Nov

Exhibit 3- RCA Commercial Property Price Index (CPPI) YoY change as of Nov Chart
Source: Real Capital Analytics, Manulife Asset Management, as of December 31, 2017.

Office Markets

While overall office vacancy has remained near historic lows through 2017, the wave of supply coming to market over the next six months is expected to slightly push up vacancy levels from 10.1% to 10.3%.3

With overall job growth expected to moderate over the next few years and more options available for tenants to choose from, we expect overall market fundamentals to marginally soften over the next few years. However, expected supply remains restrained and concentrated in few markets. Total office under construction was 119 million sq ft, equivalent to 1.5% of existing stock as of end of 2017. In contrast, the construction activity peaks in 2000 and 2007 reached 3.4% and 2.2% of stock respectively. Furthermore, the top five markets of New York, Washington, San Francisco, Dallas, and Seattle account for almost half of total projects under construction. Accordingly, we expect quality assets as well as those located in desired locations to continue to operate at high occupancy levels.

Rents continued to increase through 2017, with asking rents going up by 1.6%. However, the growth rates have clearly decelerated from the peak in 2015, when rent growth were close to 6.0%. If the demand continues to moderate we expect rent growth remain at current level for the next couple of years.

Exhibit 4- Office Fundamentals

Exhibit 4- Office Fundamentals Chart
Source: CoStar, Preliminary Q4 Forecast, as of December 31, 2017.

Industrial Markets

Industrial occupancy gains and rent growth outperformed all other asset types by a significant margin over the past few years. Demand for Industrial space has historically been linked to overall economic growth. However, acceleration in e-commerce and the resultant requirement for logistics space has driven demand significantly above overall economic growth over recent years.

In response to strong demand, construction activity peaked upwards over the past few years and as of Q4 2017 stands at 145 million square feet. Construction is concentrated in major logistics hubs, with Inland Empire, Dallas, Atlanta, Chicago, and New York, accounting for 28% of total projects. Deliveries in 2018 are expected to temporarily push vacancies higher, but the additional supply is forecasted to be fully absorbed by end of the next year.

Despite a healthy construction pipeline, overall industrial vacancies continued to decline in 2017, with total demand matching supply at 177 million square feet. Rent growth remained strong at annual rate of 6.8% in 2017, slightly below this cycle’s peak rate of 7.2% in 2016. As transformation of logistics network to accommodate e-commerce matures and supply increases, we expect overall rent growth to moderate over the next three years.

Exhibit 5- Industrial Fundamentals

Exhibit 5- Industrial Fundamentals Chart
Source: CoStar, Preliminary Q4 Forecast, as of December 31, 2017.

Multifamily Markets

Strong fundamentals and lower perceived risk attracted record investments into multifamily asset class in recent years, but as yields on existing assets continue to fall investment flow is shifting to construction.

For the full year in 2017, supply and demand remained relatively in balance with net absorption of 224 thousand units against new supply of 232 thousand units. However, with construction activity at an elevated 520 thousand units, supply is forecasted to outpace demand by a larger margin, pushing up national vacancies. National average figures though can mask the wide differences between markets, and with multifamily demand being highly localized, many submarkets remain undersupplied.

National rent growth continues to moderate with annual growth at 2.2% for 2017. Affordable markets have outperformed in rent growth, with Orlando, Sacramento, Inland Empire, Phoenix, and Tampa being the top 5 markets. Going forward we believe markets with favorable job growth and cost of living to continue to perform well.

Exhibit 6- Multifamily Fundamentals

Exhibit 6- Multifamily Fundamentals Chart
Source: CoStar, Preliminary Q4 Forecast, as of December 31, 2017.
1 Bloomberg, as of September 30, 2017.
2 All investment market data on this page, including transaction volumes, cap rate, and mortgage data are from Real Capital Analytics, as of December 31, 2017.
3 All market statistics in the remainder of this document, including supply, demand, vacancy, rent growth and construction activities are from CoStar, as of December 31, 2017.
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The opinions expressed are those of Manulife Asset Management™ at the time of publication, and are subject to change based on market and other conditions. The information in this article including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Asset Management disclaims any responsibility to update such information. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife Financial, Manulife Asset Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Asset Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Asset Management.

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