In a Rapidly Changing Economy, U.S. Real Estate Offers Solid Opportunities

By Josh Kane, Senior Vice President at Clarion Partners

Commercial real estate markets have been rising steadily for nearly a decade; however, this recovery has been much more gradual than in many post-recession cycles in the past – and that measured pace has been quite positive for the industry and investors alike.

This methodical growth has continued to highlight the important attributes that direct real estate can bring to an investor’s portfolio, namely strong risk-adjusted returns and steady cash flow, with lower volatility than virtually all public asset classes. Given the low correlations with listed REITs, stocks and bonds, direct real estate can provide true diversification from the daily swings of global financial markets.

Commercial real estate fundamentals in the U.S. are positive and continue to improve. In most U.S. markets, occupancy rates range from 90%-95% across all major property types, well above the long-term average.

Moreover, the expansion of the U.S. economy has been quite healthy with, annual real GDP growth exceeding the 20-year average in four of the last five years. Unemployment is currently at a 50-year low and consumer spending continues to rise. These economic factors are very positive for real estate overall as, they drive solid rental growth, especially for the industrial and multifamily markets, as well as select office markets.

As always, supply and demand fundamentals remain essential to real estate performance, and simply put, new supply continues to lag demand growth nationally. While many who aren’t in the real estate industry may see an abundance of construction cranes in their cities, the new supply of commercial properties being delivered is not keeping up with demand. In fact, it’s significantly below historical averages for all property types.

Factors such as stricter lending requirements post-global financial crisis, as well as increased construction and labor costs, have helped to keep supply in check and curb the excess speculative development seen in previous cycles.

Obsolescence also plays a major role. A significant paradigm shift is happening in the way tenants utilize industrial, office, retail and multifamily properties. Tenants demand modern functionality to meet the needs of a rapidly changing economy. For offices, tenants want unique, dynamic and flexible spaces with open floor plans, as well as access to amenities such as outdoor space, transit hubs and healthy food options. The adjacency to amenities also applies to apartments.

This evolution is even more apparent when it comes to industrial space. E-commerce is driving the warehouse and logistics industry swiftly into the 21st century, but with over 75% of current industrial assets built before 2000, a significant number of these properties may no longer fit what tenants require as they seek to modernize their supply chains.

Many assets have become obsolete much sooner than expected, either by functionality or by location. This accelerated obsolescence can be caused by factors such as insufficient ceiling heights, inadequate parking ratios for larger workforces, too few loading docks to handle increased volume of goods, or inefficient locations to satisfy the needs of an on-demand world.

Seven percent of existing warehouse stock is expected to become obsolete over just the next five years, which is a substantial figure in such a short timeframe. That means potentially 500 million square feet of space will have to be redeveloped – or more likely, demolished and newly built from the ground up. To put this in perspective, 500 million square feet represents nearly half of all new warehouse supply delivered since 2010.

Though it has grown significantly over the past 20 years, e-commerce currently represents only about 12% of total retail sales in the U.S. This, however, is projected to grow to over 30% of total U.S. retail sales in the next decade. Furthermore, e-commerce tenants use roughly triple the amount of space compared with a traditional warehouse user. These two factors, combined with the rapid pace of obsolescence, provide a massive opportunity for commercial real estate to play a major role in shaping the future of the U.S. economy.

The story goes beyond traditional e-commerce firms. Traditional brick-and-mortar retailers are being forced to modernize their operations and sell products online in order to remain competitive. Home Depot, America’s largest home improvement retailer, has announced plans to invest over $1.5 billion into its e-commerce business. This includes opening 170-plus new “last mile centers” – distribution hubs close enough to consumers to offer one-day or even same-day delivery. They also plan to operate as many as 10 new regional logistics and distribution centers, each anticipated to be over one million square feet in size.

On the demand side of the equation, demographic trends in the U.S. also bode very positively for real estate. The oldest Millennials are just entering their peak spending years (ages 35-54) – and it will take over 30 years for the entire generation to pass through this stage. Since 2005, homeownership is down across all age groups, and Millennials now tend to rent rather than buy property. This is due to several factors facts, including flexibility, affordability and a desire to live near the areas where they work and socialize.

Behind the Millennials is the Generation Z cohort, the largest generation in American history, which happens to be nearly 20% larger than the Millennials. When combined, these two groups total roughly 160 million people. These demographic forces, which are driving demand for new U.S. household formation, job creation and consumer spending, provide substantial long-term support that can help counteract other potential future economic headwinds.

All told, the U.S. real estate market is fundamentally strong. Steady growth, combined with a generational shift toward modernization, presents many compelling opportunities. For long-term investors bullish on the future of the U.S., this may be a good time to consider direct investments in commercial real estate.

Josh Kane is a Senior Vice President at Clarion Partners, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.

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