Adaptation is Key as Real Estate Continues to act as a “Shock Absorber” Amidst Increasing Market Volatility in North America
CHICAGO (July 26, 2018) — According to LaSalle Investment Management’s (“LaSalle”) Mid-Year Investment Strategy Annual (“Mid-Year ISA”) 2018, the real estate portfolio strategies recommended in last December’s ISA generally held up against both expected and unexpected market forces throughout North America, despite being faced with abrupt changes including structural and cyclical shifts. In summary, real estate continued to perform as a “shock absorber” against market volatility that picked up in both the fixed income and equity markets. The U.S. and Canadian real estate markets continue to see the Goldilocks theme holding up as the odds of a financial crisis or a major global recession remain very low for the rest of year. Looking ahead, the probability for a continued global expansion remains high for 2019.
LaSalle clients can view the full report at: https://www.lasalle.com/research/reports/2018-isa-mid-year-update
The Mid-Year ISA also takes a deeper dive into technology in urban economies, the capital markets and real estate markets. Technology is having a major impact on the way financial institutions organize data for privacy, speed and efficiency. The rise of blockchain technology has created an ever-increasing demand for the way data is utilized, stored and managed, yet real estate sits several steps removed from the direct impact of the blockchain evolution. The intersection of Fin-Tech and Prop-Tech start-ups have been accelerated by the $6 billion in growth capital provided to companies that bring new technologies to real estate.
Jacques Gordon, Global Head of Research and Strategy at LaSalle, said: “Thus far, 2018 has shown adaptability to the structural, secular and cyclical changes that have rolled through the commercial real estate market. Our mid-year update indicates that core real estate continues to perform at an appropriate level, relative to other asset classes, and that the inclusion of real estate raises portfolio returns, for a given level of risk. With looming trade wars, geo-political tensions, and differential exposure to rising rates, this pattern of highly-correlated global growth could be coming to an end. Our mid-year update indicates that the last six months have raised the probability of country-specific differentiation, as both positive and negative trends unfold in the final six months of the year.”
Since last December’s ISA was published, the U.S. has experienced policy shifts that have led to changes in the economic outlook with limited impact on the real estate capital markets and fundamentals. Macro-economic factors, including the combination of tax cuts and greater spending, have given rise to a meaningful stimulus at a time when the U.S. economy is already experiencing good momentum and low unemployment. The Federal Reserve has made three increases in interest rates, and yet with all of its prior stimulus, there are a few signs of inflation or wage growth due to structural changes in the U.S. labor force. Near-term growth trajectory and the accompanying higher interest rates have not yet made a measurable direct impact on the commercial real estate market. Trade policy has been in the spotlight since the election of President Trump. And while the U.S. capital markets began 2018 with turmoil, the real estate capital markets have been mostly tranquil.
While Canada has not had any major rollout of an aggressive economic stimulus package similar to the U.S., in the long run, the Canadian economy will not be burdened with a huge debt overhang. New mortgage rules and higher interest rates cooled housing activity, prompting a lower GDP reading. This, however, has not changed the investment outlook given the fact that segments key to commercial real estate – including business investment, commercial structures and imports – were all positive and should continue to drive space demand.
Bill Maher, Head of North America Research & Strategy for LaSalle, said: “Substantial global change has occurred since our 2018 ISA was published. The U.S. policy shifts have led to changes in the economic outlook, with Canada’s major markets are navigating different phases of the cycle. The one major surprise – and downside economic risk – is the ongoing trade dispute between the U.S. and Canada, which reached new levels following the G-7 summit. The imposition of tariffs by the U.S. against Canada (and Mexico and the EU) on steel and aluminium products was countered by the threat of tariffs on many U.S.-made imports. Tied to this, NAFTA negotiations have advanced, but a final agreement remains elusive and until finalized, the trade issue and tariffs remain significant risks for Canadian economic growth.”
The Mid-Year ISA also shows that the REIT market has generally underperformed in 2018, and was at a 5 to 10 percent discount to Net Asset Value (NAV) in mid-June with this price gap leading to M&A and privatization activity. The increase in interest rates has also yet to impact private core real estate pricing. U.S. capital flows to real estate appear on firm ground, with many domestic pension funds under-allocated to real estate. However, cross-border capital flows into real estate could be impacted given that they are under closer scrutiny in several countries and could be subject to cross-border taxation if caught up in a trade war.
Rich Kleinman, Head of U.S. Research and Strategy for LaSalle, said: “At the mid-year mark, cracks are beginning to show in the pricing of well-leased retail properties and office buildings that don’t offer tenants amenities, either inside or outside the building. An astute investor will look for value in oversold or out-of-favor situations, which can be found in both the listed sector and the private equity market. While select strategy recommendations have been adjusted, notably in the industrial sector due to the surge in core pricing, much of the strategy remains the same as was published six months ago.”
Select North American property sector insights from the Mid-Year ISA, include:
- Apartments: Suburban markets continue to be favorable in the U.S., yet our attention is also turned back to a few urban locations. Certain urban apartment markets impacted by the first round of new supply are now seeing supply fall from highs and might be investment targets in the next year. Suburban apartments were slower to recover, and new supply in those locations remains mixed with some nodes seeing a pick-up in new construction. New supply in localities with greater restrictions on new development remains limited. Overall, rent growth on new leases is lower than in past years, but renewal rent increases are remaining firm. Canadian investors are seeing good NOI growth in the apartment segment. Also, the weight of capital seeking product in Canada remains strong, with no trading volumes likely to be similar to last year’s record rate (>$40 billion). Urban apartments, a core opportunity highlighted in the ISA 2018, remains attractive.
- Retail: In the U.S., e-commerce continues to re-shape the retail landscape. Toys R’ Us was the biggest casualty of the last six months, and that will leave new voids in power and community centers. Similar to many other cases, it was a combination of secular changes and poor management – in this case, exacerbated by elevated levels of debt – that caused the final demise. The tenant base of grocery-anchored centers remains stable, while the mall space is under a considerable amount of stress – especially among lower quality malls. In Canada, core retail was an underweight tilt in the December ISA, and thus far that has been correct as retail returns have underperformed the IPD Annual Global Property Index (IPD) benchmark. Regional and super regional malls, which once led the IPD in returns, have been impacted by Sears Canada’s first-quarter bankruptcy and growing store closings. Urban opportunities are recommended for core retail while higher return retail strategies require compelling value levers, such as densification, lease-up or development opportunities.
- Warehouse/Industrial/Logistics: U.S. industrial occupancy leveled off after several years of strong demand and sharp availability rate declines. The primary driver is a slowdown in absorption from the record levels in 2015 and 2016, with slightly higher new supply being a secondary factor. Rent growth forecasts are reduced for the sector in 2020 to 2021 due to the fact that the current environment is attractive for development. Meanwhile, pricing for industrial assets continues to climb as the sector’s out-sized returns over the last several years leave most investors looking to retain high-quality assets. Many investors seeking to increase industrial investment with fewer opportunities to buy, resulting in record pricing. In Canada, industrial has become one of the strongest performing sectors in the IPD Index, with availability at historic lows and new supply not keeping pace with demand. Supply-constrained logistics markets such as Toronto and Vancouver are recommended as a focus for investors.
- Office: The U.S. office market is seeing a focus on efficiency in space usage, which is limiting demand and causing vacancy rates to creep higher. There are only a few markets that have sustained low vacancy driven by strong demand that is leading to strong rent growth. In the last six months, strong leasing in the tech hot spots of Seattle and San Francisco has been surprising, reducing the likelihood of a supply-induced downturn in those markets. Co-working also continues to impact the market, reducing demand for traditionally leased buildings by smaller tenants although positive overall.
- Niche: Sectors including medical office and self-storage, with core-like cash flows and manageable operational risk, are seeing strong investor interest. Recent changes to the Affordable Care Act (ACA) will likely have little impact on medical office demand. Self-storage is starting to show the effects of the weight of capital that has come into the segment in the last several years, as pricing is up and new supply is elevated. This segment should continue to deliver stability, but with lower expected growth and pricing premia. Canadian office vacancy peaked in 2017, and the recovery is expected to be slow and steady. Rising oil prices thus far in 2018 have been a positive for Alberta in terms of higher GDP, but there is not yet a meaningful improvement in real estate fundamentals. Midtown Montreal and suburban Vancouver are experiencing tech demand, making the tech node office lease-up appealing.
About LaSalle Investment Management
LaSalle Investment Management, Inc. (together with its global investment advisory affiliates, “LaSalle”) is one of the world’s leading real estate investment managers. LaSalle on a global basis manages approximately $60 billion as of Q1 2018 of private and public equity and private debt investments. LaSalle’s diverse client base includes public and private pension funds, insurance companies, governments, corporations, endowments and private individuals from across the globe. LaSalle sponsors a complete range of investment vehicles including separate accounts, open- and closed-end funds, public securities and entity-level investments. LaSalle Investment Management, Inc. is a wholly-owned, operationally independent subsidiary of Jones Lang LaSalle Incorporated (NYSE: JLL), one of the world’s largest real estate companies. For more information please visit www.lasalle.com.
This information is based on the market analysis and expectations of LaSalle and should not be relied upon by the reader as research or investment advice regarding LaSalle funds or any issuer or security in particular. The information presented herein is for illustrative and educational purposes and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy in any jurisdiction where prohibited by law or where contrary to local law or regulation. Any such offer to invest, if made, will only be made by means of a private placement memorandum. Past performance is not indicative of future results.