The U.S. property market landscape in 2017 will be characterized by continued strong fundamentals, increased investor flows, and high transaction volume. As for the economic landscape, the U.S. continues to grow moderately and add jobs. U.S. employment gains continue to be strong, with unemployment dropping below 5 percent earlier last year, and adding to demand for commercial real estate in a variety of sectors. Many are surprised we have not reached the end of the current economic growth cycle. The fact that the recovery was so protracted and that growth relatively anemic over the last seven years leads me to believe that we may have another two years left in the current growth cycle.
The U.S. Federal Reserve made it clear last December that the central bank sees U.S. growth as relatively stable, notching the federal funds rate higher by a quarter point in early December. This is only the second time since 2006 that the Fed has raised rates (the last time was in December 2015). “Economic growth has picked up since the middle of the year,” said Janet Yellen, the Fed’s chair. “We expect the economy will continue to perform well.” Nevertheless, underlying inflation is extremely tame in the United States and in major emerging markets (with worries of deflation in some sectors and countries), providing no impetus for significantly higher rates. Lending rates and fixed-income rates of return will still be very low by historical standards, inducing continued levered purchases of real estate assets.
Now for the elephant in the room—what are potential impacts of a Trump presidency?
Over the last two months, many in the public and private sectors have been scrambling to speculate on what a Trump administration will bring. Trump has pledged to make massive changes in our economy, regulatory environment and government, but it remains to be seen, even with a Republican majority in both houses, how much change can really take place. While Trump is famous for making, then changing and even retracting statements, many see a few common themes in his rhetoric that could play out in the economy over the next year or two.
His focus on the economy, economic competitiveness and initiating a long-term trend in higher infrastructure spending could trigger slightly higher GDP growth, higher inflation and a stronger dollar. Higher inflation would cause the U.S. Federal Reserve to increase rates, even more than the gradual and protracted pace today. Higher rates will be good for banks and savers, but not so good for bonds and assets that are typically levered such as real estate. He has also committed to lower corporate and personal tax rates and granting a one-time tax holiday for U.S. corporations to repatriate profits to the U.S. at a lower tax rate. Lower tax rates could spur investment and savings which could lead to growth across the board in commercial real estate.
However, if public sector spending is not cut at the same time, it could lead to massively more government debt, which could depress economic growth and inflation causing the Fed to pause in their rate hike regime. If firms with profits abroad repatriate the huge pool of capital, estimated to be around $3.5 trillion, we might see a significant stimulus for the economy, particularly if it goes towards new investment and personnel and not simply stock buybacks.
Trump has also promised to dramatically reduce regulation. U.S. business are some of the most regulated in the world. Reduced and simplified regulations at all levels of government would allow business to operate with fewer constraints, potentially reducing costs, opening new areas of business and making the business environment easier to negotiate particularly for small and mid-size businesses, the bulk of U.S. private sector employment. He has threatened to increase the capital gains tax to the higher corporate tax rate. This would create a huge disincentive to invest in private real estate, where investors typically benefit from long-term capital gains tax treatment. He has made it clear he would like to reduce regulation on coal, shale and oil industries, which could lead to higher profits and growth for firms in this industry and could benefit those regions with a higher concentration of energy activities such as Texas and the upper plains states.
These five trends will play a significant role in commercial real estate in 2017 (Trends 1-3 are presented here, with Trends 4-5 in Part 2):
1. Global Economic and Political Uncertainties
The Brexit vote in the United Kingdom has added new uncertainties that will not be fully understood, much less resolved, in the near term. Trump’s election in a way signaled the continuing populist revolt of the West, with governments in France, Italy and Germany potentially leaning more towards a nationalistic policies and leaders. Trump has been very vocal in his disapproval in trade agreements. Expect higher tariffs for several countries including China, Mexico and South Korea and potentially many others. This could usher in a new wave of deteriorating relationships with these countries. Higher tariffs would also mean higher prices for a wide variety of consumer and industrial goods that the U.S. imports, putting pressure on higher inflation. The International Monetary Fund (IMF) has downgraded global growth twice since January as uncertainties blur the outlook.
For U.S. markets – real estate in particular – the impact is likely to be largely positive as U.S. assets become more attractive and valuable to global investors. We can probably expect enhanced inbound foreign investment in U.S. real estate markets as the U.S. becomes even more of a safe haven. The IMF predicts higher economic growth in the world as emerging markets find their footing and commodities continue their recovery. Stronger global growth is likely to provide more real estate inflows into the U.S. market.
Exhibit 1: World Economic Outlook Projections
(Source: International Monetary Fund, October 2016.)
2. Continued Strong Foreign Capital Flows
Foreign Investment in the US. Global economic and political uncertainty continues to drive capital to the United States, the Trump Presidency notwithstanding. International capital flows into U.S. real estate assets will continue—and increase. The U.S. property market is the most stable and transparent in the world, with higher relative yields and price appreciation potential, making it an easy investment choice.
And, while slowing growth in China and much of Europe may dampen currencies and incomes overseas, there is still abundant non-U.S. capital looking for placement and very strong demand for U.S. assets, as 2015 proved with record inflows. In 2015, foreign purchases of U.S. real estate assets rose to more than $87 billion over the 12 months ending in December, according to the Association of Foreign Investors in Real Estate (AFIRE), with China, Canada, Norway, Singapore, all riding the wave. That volume is up from just $4.7 billion in 2009, according to Real Capital Analytics. Among members of AFIRE, a substantial proportion expect to increase investment in the United States in 2017. Changes in the 1980 Foreign Investment in Real Property Tax Act (FIRPTA), which now allow foreign investors to be treated in a fashion similar to their U.S. counterparts, will likely lead to an increase in foreign investment in the U.S. real estate market as well. While Trump has been rattling the saber against foreign good imported into the U.S., he has said nothing against inbound foreign investment in domestic commercial real estate.
Exhibit 2: Foreign Acquisitions
(Source: Marcus & Millichap Special Foreign Investment Report, 3Q 2016)
3. Low Interest Rate Environment
Fed officials raised its target for short-term interest rates by 0.25 percentage points on December 14, 2016. The Fed’s most recent forecast projects U.S. economic growth in 2017 to be 2.1%, slightly better than the Fed’s previous projection in September. Trump’s expansionistic policy rhetoric—pledging significant spend on new infrastructure, higher exports, higher import tariffs, lower taxes and reduced regulation could spur inflation and lead to higher interest rates.
Many have predicted the end of the 35-year bond bull run and the end of record-low interest rates. Yields, which had fallen to as low as 1.5% in the immediate aftermath of the Brexit vote, have risen back to over 2.14% as of November, 2016, according to data from the Federal Reserve Bank of St. Louis. As concerns about global economic developments ease, we should expect those yields to push back toward a more normalized 1.75% to 2.0% range by early 2017.
Exhibit 3: 10-Year Treasury Constant Maturity Rate (percent, monthly, not seasonally adjusted)
(Source: Federal Reserve Bank of St. Louis)
Private equity real estate funds generally follow core, core-plus, value added, or opportunistic strategies when making investments. “Core” refers to an unleveraged, low-risk/low-potential return strategy that seeks predictable cash flows. Characteristic properties are typically stable, fully leased, multi-tenant properties within strong, diversified metropolitan areas. “Core Plus” is a moderate-risk/moderate-return strategy that generally seeks to invest in core properties; however, many of these properties will require some form of enhancement or value-added element. “Value Added” is a strategy with medium-to-high-risk/medium-to-high-return potential. It involves buying a property, improving it in some way, and selling it at an opportune time for potential gain. Properties are considered value added when they exhibit management or operational problems, require physical improvement, and/or suffer from capital constraints.
The squeeze on cap-rate spreads remains of some concern for real estate investments should rates rise more rapidly than expected, as seen with the “frothiness” we have experienced in certain gateway, Class A markets. At present, little indication exists that a rate increase will push cap rates dramatically higher. Spreads are still historically high for commercial real estate. The historical spread for core real estate over the long-term ten-year rate is about 250 basis points. For most commercial real estate, that spread is still 300-350 basis points, so we have quite a way to compress before there is upward pressure on cap rates. Nonetheless, there are indications that yields may begin to drift upward.
And, as pricing in first-tier markets stalls and yields hover in the sub–4 percent range in some of the major gateway markets—which are, in some cases, already in peak pricing territory—we should probably expect investors to move more aggressively into secondary and tertiary markets—and to opportunities beyond core assets to core-plus and value-add properties as well as some of the niche property sectors, including medical real estate. Another factor in cap rate behavior is the relative attractiveness to other alternative investments available to the investor. Currently corporate credit bonds are yielding the 2s, S&P 500 dividends are also in the 2s and public REIT dividends are in the mid-3s.* In this relative low yield scenario, average private equity real estate yields are still very attractive and continue to attract capital despite raising rates. That ongoing capital demand will put downward pressure on cap rates.