This is part 6 in a multi-part series about the latest Emerging Trends in Real Estate® report, an annual forecast on the outlook of real estate finance and capital markets, investment and development trends, property sectors, metropolitan area, and other issues affecting the industry in North America. Check out the earlier installments here.
Property Type Outlook: Part 1
One of the most fascinating features of the human race is the ability to adapt, and there are few places that have displayed this quality quite like in America. From a predominantly agricultural nation to the industrial revolution and beyond, the form and function of of our land have shifted with increased populations and technological advancements. The transformation of lofts to housing, or offices to hotels demonstrates how the needs of the people shape the real estate developments and markets. Existing properties continue to “adapt their physical design to new functional needs,” accommodating the latest and greatest of our ever-changing nation.
In this part of our series on the Emerging Trends in Real Estate® report, we’ll examine how the different real estate sectors have adapted to the times, and what we should look for in the coming years. In Part 1, we’ll take a look at the industrial and apartment sectors, with follow-up parts focused on office, hotels, retail and housing.
The American economy continues to be focused on the “stuff” consumers want and need. Although manufacturing employment has declined in recent years, output from U.S. industry has actually increased about 85% since 1987. This trend has not been lost on the real estate industry. As a result, investors like the value-for-price relationship in this property type where the average cap rate is 6.9%. They also like the downside protection provided by the triple-net leases and the cash-in-hand quality of industrials. National Council of Real Estate Investment Fiduciaries (NCREIF) data show that the recent capital appreciation is about 8% annually.
The Emerging Trends survey found that the industrials sector is easily at the top of the commercial property sector for investment and development prospects. There is a consensus among industry experts that the supply/demand fundamentals are very sound for the sector. A major life company asset manager agrees with the outlook: “We’re seeing good, strong demand. There is new construction, but it seems to be being absorbed at the pace that it’s being built.”
The demand itself is fairly diverse. The internet is a major driver with the expansion of e-commerce and a need for fulfillment centers. For the first time ever, survey participants were given fulfillment centers as an industrial segment category, and subsequently they rated it above warehouse/distribution and R&D/flex for investment potential. As many businesses look to offer same day delivery, smaller warehouses near the urban center may be in demand, as space under 200,000 square feet are currently harder to come by.
First-quarter 2015 data from NCREIF showed the Midwest with the highest total returns in industrials, when compared to the other U.S. regions. But, while construction in the industrial sector is certainly accelerating, the whole picture needs to be considered. The boom is coming off of a long period of time with little to no development, so year-over-year change is lost in the short-term. Similarly, investors should not grow nervous of the large growth rate without considering the long-term perspective. While “the big guys concentrate on the biggest assets in the biggest markets,” investors should keep an eye out for viable niches elsewhere.
The multifamily rental sector is continuing its decade-long success, but Emerging Trends survey respondents are wary of the future. While they continue to rate the sector’s prospects highly, many markets are seeing extraordinarily high prices and low cap rates, leading some to think a shift is in the near future. The executive vice president of a major national developer commented, “I have never seen the apartment sector so good. That will change. There is too much building in some markets. High rent increases will have to come down.” A private equity manager added, “This is a great market to sell. Investing is more challenging.”
Previously, the urban/suburban choice was heavily associated with the rent/buy choice, but this doesn’t seem to be the case anymore. There are now a huge range of options for consumers and developers alike, and with a very large generation Y now looking for housing, the demand for both rentals and ownership housing will expand. An analyst with one of the major housing data firms said, “the demographic forces are very positive to support residential construction, support multifamily, while serving a growing need for additional single-family housing stock.”
The garden apartment subsector has continued to enjoy a “golden era” with strong leasing activity and rent growth, even as multifamily development accelerated. NCREIF reported double-digit total returns, moving ahead of higher-density residential, mainly due to the superior net operating income (NOI) growth. During the housing recovery, pressure of institutional investment competition has pushed cap rates lower for mid-and high-rise multifamily assets, but garden apartments have maintained average cap rates about 6%. An identifiable trend in favor of the garden apartment subsector has been established in areas where multifamily housing costs are more manageable.
Some investors prefer the approach of taking profits in a market that will still be strong in the coming year, and redeploying the capital into preferred assets. A Wall Street fund manager comments on this strategy: “Our portfolio has very much evolved. We are selling out of the older-style apartments at very high prices and replacing them with newer and much more urban properties in the seven or eight target markets where we can create scale.” The urban multifamily subsector is a good bet when it comes to this strategy. And with the onset of increased educational opportunities (i.e.charter schools and homeschooling), some industry experts believe that more and more millennials will choose to stay in the cities as opposed to heading for the burbs.
On a similar note, with the evolution of 18-hour cities, more smaller markets around the nation are benefiting from additional diversity in population and economic bases. Mixed-use developments (MXD) and infill are “megatrends,” and horizontal MXD is easier (and more efficient) than vertical. These trendy developments are being seen as infill locations, not as sprawl at the perimeter spots, and projects have been exceeding projections.
More than 7.4 million homeowners are still underwater after the housing market collapse, and the recovery in the suburban housing markets is still slow. Many of the millennials who are now home shopping saw their families’ net worth evaporate in the housing debacle. It’s easy to understand why homeownership has lost some of its appeal. And with a fluid and transient job market, committing to a long-term mortgage just isn’t realistic for many. These factors combined have industry experts feeling that the multifamily rental sector will remain strong, although there are definitely markets with emerging supply issues.