Q3 2016 U.S. Investment Outlook
The quarterly U.S. Investment Outlook leverages data covering both the space and asset cycles to provide a barometer of the environment for U.S. investment across the industrial, lodging, multifamily, net lease,office and retail sectors. The report integrates analysis on key areas impacting underwriting and pricing including the financial markets, leasing and development activity, investment volumes, pricing and yields,and financing. www.us.jll.com/investment-outlook
Cautious optimism reemerging as volatility moderates in late 2016
In the third quarter of 2016, financial markets remained unfazed by the Brexit vote that took place at the end of the second quarter. The S&P 500 averaged 2162.1, with a 6.1-percent return year-to-date. As investors attempted to come to terms with a muted reaction to Brexit, limited volatility continued to be the norm. As a result, volatility averaged a mere 13.2 on the CBOE Volatility Index (VIX), and financial markets began a rally to beat all-time highs, day-after-day. Markets continued to edge higher, closing at 2190.15 onAugust 15, an all-time high for the S&P 500 Index. Continued optimism in the short-term was fueled in large part by the quick rebound from the Brexit. With this, after having barely moved for 43 consecutive days this quarter, recurrent concerns related to global monetary policy, OPEC and the FOMC rate decision reemerged as areas of concern, causing markets to move and the VIX to increase:
- Looming concerns of an overheating market and increased stimulus in Europe spurred the most volatile week of the quarter;
- Oil prices and production fears subsequently became an issue on September 14, as oil prices declined, causing the VIX to reach 18.4, the highest point of the quarter; and
- Expectations of a surprise September rate hike further added to market sell-off concerns; though rates remained unchanged, specific call-outs to the commercial real estate market were made by the FOMC.
Despite continued bumpiness this quarter, the severity of that velocity was muted, especially when compared to the prior 12 months: Quarterly minimum, maximum and average VIX levels represented the lowest of the most recent five quarters. Amidst moderating volatility, the 10-year Treasury has seen continued declines, reaching as low as 1.36 on July 8—further reinforcing the ‘safe haven’ status of U.S.bonds and depressed yield environment. The 10-year has since increased, closing the quarter at 1.60. This represented the second lowest quarterly close of the current expansion, the lowest being the second quarter of this year. Throughout this period, property valuations overall have continued to rise, increasing between 4.5 and 5.5 percent, according to the CPPI and NPI indices.
Since the third quarter of 2015, equity markets have continued to see bumps in the road. Given increased perceptions of downside risks and the reactive nature of equity markets to macro shifts, expect to see more bumpiness. With this, catalysts such as the FOMC and elections in the U.S. and abroad should be closely monitored. However, the moderated pace of recent volatility is paralleling a reversion of investor sentiment to that from the spring of 2015, increasing cautious optimism. With strong, sustained liquidity in commercial real estate debt and equity markets, this ‘resetting’ of investor sentiment positions the markets well for stable growth heading into 2017.
As annual volume declines moderate in the third quarter, pricing coming to the forefront
Following quarterly declines in four of the five sectors and an overall year-to-date decline of 17.7 percent at mid-year, increased third quarter activity moderated volume declines at the close of the quarter. With three of the five sectors (hotels, office and industrial) rather seeing quarterly gains, year-to-date activity is now down 7.1 percent:
- While down on the year by 31.5 percent, the hotels sector saw an 86.4 percent increase in
quarterly activity, largely attributed to the $6.5 billion purchase of Strategic Hotels & Resorts by Chinese insurance company Anbang.
- Office led quarterly and now leads year-to-date volumes with $35.5 and $101.4 billion of transactions, respectively. The sector has seen a return of diversified growth across primary and secondary markets, with risks sensitivities sustained at the submarket level—leading non-CBD liquidity to revert to late-2014 levels.
- The industrial sector additionally saw quarterly gains of 2.3 percent, a function of increased single asset and single market-focused portfolio transactions.
- While down modestly this quarter, the multifamily sector remains an outlier with year-to-date volumes up 8.2 percent; increased portfolio and single asset sales in secondary markets—notably on the West Coast—remain key drivers of activity.
- For the retail sector, mall and urban product in secondary markets are driving deal flow. Of note,this has paralleled an emergence of higher-quality transactions, bringing opportunities to active investors who have been patiently waiting on the sidelines.
- Despite volumes still down year-over-year, the net lease sector continues to benefit from an
expanding investor base—notably, from offshore, institutional and equity fund investors; this has paralleled the emergence of larger, institutional-quality single assets sales and sale leasebacks.
A consistent theme across the hotels and office sectors remains the impact of offshore capital. Foreign capital has seen a relative decline in participation on U.S. acquisitions, decreasing from 15.4 percent at year-end 2015 to 9.6 percent year-to-date. However, the hotels and office sectors have maintained strong and increasing levels of offshore participation: Offshore capital has accounted for 42.7 percent of hotels acquisitions year-to-date, and for the office sector, foreign investment has continued to see structural gains this cycle relative to the prior peak. In the prior peak volume years, offshore participation averaged between 5.0 and 9.0 percent, and this has continued to rise, reaching 15.6 percent at year-end 2015 and nearing15.0 percent at the close of the third quarter.
While investor sentiment is stabilizing and volume declines moderating, selectivity remains the norm across investor types, sectors and markets with an increased focus on downside risk mitigation and cycle assurance, impacting liquidity for higher risk submarkets and higher-priced, core opportunities in select sectors and markets. As we move into 2017, pricing will be a key factor to watch, especially in historically less-liquid segments of markets. Thus far, while the industrial and retail sectors continue to see compression, the office and multifamily sectors are exhibiting signs of plateauing, with the hotels sector seeing a 30-basis-point softening of cap rates over the last 12 months. As long as sector fundamentals remain strong, we expect any near-term softening of cap rates to remain subdued.
CMBS spreads stabilizing, although divergence remains across tranches
After coming off a low volume of both first-half and summer CMBS issuance, activity has picked up, albeit conservatively. However, CMBS issuance is still only at $49.9 billion year-to-date versus $77.6 billion at this time last year, representing a 35.7 percent decline. Since the increase in volatility in August of 2015, CMBS spreads across tranches have seen notable instability, varying nearly 70 basis points for AAA and more than 400 basis points for BBB-. However, with muted volatility in markets, lower risk tranches are moving toward stabilized levels, a key for the CMBS financing outlook. Compared to AAA spreads of 99 basis points on July 31st of 2015, AAA spreads reached as low as 102 basis points in August. However, the higher risk tranches remain volatile with BBB- spreads at sustained, elevated levels not seen since the summer of 2012, reaching 615 basis points at the close of the third quarter. While CMBS pricing has not yet reached normalized levels, markets are working toward stabilization, a plus for the issuance outlook and for markets historically more reliant on CMBS financing. However, despite uncertainty due to the reactivity of spreads to spikes in the financial markets and pending risk retention rules, CMBS lenders are still lending at healthy rates, a key for markets given the approaching ‘wall of maturities’ heavily concentrated over the next five quarters.
Liquidity landscape strong and evolving across debt and equity markets, favoring debt funds and higher-yielding equity strategies
In the wake of increased regulatory pressures for banks and CMBS lenders, alternative lenders continue to step in to fill the void. While overall fundraising year-to-date is down 17.9 percent, debt fundraising continues to lead the way with a 77.8 percent increase. With this, closed-end debt funds have raised a historic $14.5 billion and are on pace to see historic annual fundraising levels. Over the last six months,AllianceBernstein, Paramount Group, Kayne Anderson, Madison Realty Capital and Walton Street have each closed debt funds exceeding $500 million—the largest being AllianceBernstein’s $1.5 billion debt fund, targeting senior debt positions across sectors. Conversely, though opportunistic and value-add fundraising has grown in recent history, recent data suggests a slight slowdown. Opportunistic fundraising notably is down 45.3 percent year-to-date. As a result, whereas opportunistic capital comprised nearly 55.0percent of funds raised at this point last year, debt funds have expanded from 13.3 to 18.8 percent of capital raised year-over-year. Closed-end core fundraising has been and remains constrained with those recently closed funds sector-focused and on the industrial and retail sectors, a divergence from more diversified strategies adopted by the opportunistic and value-add funds.
Despite declining fundraising, liquidity in both the debt and equity markets remains strong, partially due tothe amount of dry powder sitting on the sidelines. Dry powder remains at a record $239 billion globally with57.3 percent focused on North America. This represents an increasingly disproportional focus on NorthAmerica, primarily the U.S., with this percentage now at the highest level seen since 2004. Looking ahead,as investors adopt latter cycle strategies, debt fundraising is expected to remain strong, filling the financing gap at lower-risk positions in the capital stack amidst regulatory-pressures on traditional lenders. On the debt side, opportunities remain for alternative lenders and debt capital to participate in mezzanine and bridge lending. On the equity side, dry powder will continue to benefit higher-yielding opportunities with more constrained liquidity for core opportunities outside of the established gateway markets—notably,Boston, New York, San Francisco and Washington, DC.
REIT performance improving with aid of stabilizing financial markets, liquidity and GICS
REITs are returning to the limelight, as investors begin to realize the value of the sector from a relative value and real estate exposure perspective. With this, following a decline in REIT performance in 2015, the all equity REIT index has returned 12.3 percent year-to-date, outperforming the S&P 500, which is returning6.1 percent. While multifamily REITs have outperformed in recent years, industrial and retail REITs are now seeing leading performance, with year-to-date returns of 31.1 and 13.1 percent, respectively.
Despite these gains and the popularity of REITs, a depressed IPO market remains with only two IPOs so far this year, the lowest number of IPOs since 2008. In addition to recent volatility in markets, the lack ofIPOs could be attributed to increased confidence in raising capital elsewhere. Secondary equity raises year-to-date have already surpassed last year’s levels at $26.5 billion versus $25.7 billion in full-year 2015.As secondary markets are one form of alternative fundraising, foreign capital and other private lenders have also aided in providing alternatives to the IPO market. Strong balance sheets, disciplined investment strategies and liquidity in real estate markets are simultaneously driving REITs ability to raise capital through monetizing assets which are non-core to portfolio strategies. In 2016 year-to-date, REITs at-large have been net sellers, rightsizing portfolios of $26.4 billion of product. This is creating opportunities for foreign investors and equity funds, both of which are active in deploying capital in the U.S. and have thus acquired $9.3 and $14.0 billion, respectively, net of dispositions. These factors are aiding REITs in maintaining popularity as equity markets continue to digest new changes in the sector.
REIT liquidity is further being boosted by structural shifts to the Global Industry Classification Standard(GICS) structure, with listed equity REITs and real estate management and development companies being carved out from the Financials sector effective September 16th, creating a stand-alone industry named RealEstate. The resulting exposure and enhanced transparency to the sector is expected to increase interest from institutional investors, individual investors and financial advisors, increasing the likelihood of longer-term strategic allocations to real estate. Gaining exposure to real estate via ETFs or other REIT securities has already seen an uptick. Leading up to the change, REIT ETF investors invested on average $641million, with the biggest inflow of $4.5 billion from Vanguard’s REIT ETF. With capital deployment pressures high, equity REITs outperforming the S&P 500 at-large and markets for direct opportunities increasingly competitive, this structural shift is expected to bring in excess of $100 billion of capital into real estate via the public markets, with REIT products and offerings expected to further evolve in the mid- to long-term.