Real Estate: 2018 Investment Outlook

Real Estate: 2018 Investment Outlook

Three key themes for the coming year: increased demand for warehouse space driven by e-commerce expansion; massive pent-up housing demand among young adults; and a challenging global interest rate environment.

In 2017, the U.S. economy and real estate market showed great resilience despite the “wall of worry” that built up around political stalemate in Washington, the Fed’s momentary agenda, recovery from recent climate-related disasters, and rising anxiety over the maturing business cycle. Such concerns have not subsided, but Clarion Partners believes that underlying fundamentals and relative value warrant measured optimism for real estate investors in 2018.

We expect real GDP growth to be approximately 2.8%, faster than the average 2% annual pace over the past seven years. Furthermore, for the first time since 2011, economic growth is accelerating among both developed and emerging economies. Synchronized global growth should help extend the U.S. economic expansion. The continued strength of the U.S. economy will support robust corporate profits, a tight labor market, and rising household formation, each of these in turn bolstering commercial real estate demand.

Our baseline scenario expects demand to strengthen as new supply remains in check, resulting in an acceleration in Net Operating Income (NOI) growth as well as in property appreciation relative to that of the last two years. As market occupancy approaches 95%, property owners should be able to raise rents. Because demand is healthy in many markets, value-add opportunities to generate higher total investment returns could continue to present themselves.

In our view, value creation is being driven by three major investment themes:

E-commerce:The first is the shift in consumer behavior caused by e-commerce fueling an unprecedented expansion in the industrial warehouse sector. Investor appetite for both current and next generation warehouses, including big-box fulfillment distribution centers and small infill warehouses for last-mile delivery, will remain high even as pricing moves past prior market peak.

Urbanization: The second is the massive pent-up demand for housing among young people. Over the next five years, many of the 23 million millennials still living with their parents along with the front-end of Gen Z – a generation cohort estimated to a quarter of the current national population – will move into apartments in urban core employment centers.

Interest rates: The third theme is the challenging global interest rate environment that has resulted in more than $7 trillion of sovereign bonds with negative yields. Given its attractive fundamentals, large investment universe, and high transparency, the U.S. real estate market is positioned to further capture international cross-border capital flows.

The new tax reforms favor the commercial real estate asset class and all property sectors.

No changes were made to the existing FIRPTA (Foreign Investment in Real Property Tax Act), 1031 revenue reinvestment laws, LIHTC (Low Income Housing Tax Credit) or carried interest rules, which means commercial real estate continues to remain attractive to both domestic and international investors.

The change to the mortgage interest rate and property, and state and local sales taxes may deliver benefits to commercial real estate investors, particularly multi-family property investors in high-cost metro regions such as New York, Boston, Los Angeles, DC and the Bay area, as workers shift from homeownership in the suburbs to renting closer to their jobs. In addition, renters may have more disposable income available to pay the higher rents required in high-cost markets - which is good news for landlords.

REIT investors will benefit from the tax breaks that “pass through” businesses will receive as investors will be now allowed deduct 20% of their REIT dividend income.

The retail sector, while still volatile, will potentially benefit as retail companies realize much lower corporate tax rates (as retailers often have fewer intellectual property and other tax write-offs that lead many companies to already pay a lower-than-21% tax rate). In addition, as consumers feel they have more disposable income, they may spend more of it in brick and mortar storefronts as indicated by better-than-expected holiday sales.

Companies, realizing the benefits of lower tax rates and $3 trillion in overseas revenues being brought back into the U.S., will spend some of that money expanding their footprint and investing in newer, more flexible and technologically capable office spaces.

Lastly, higher consumption will drive more distribution demand which supports continued investment and growth in the already strong industrial sector.

Risk to our outlook

We are monitoring several risks,  including higher-than-expected wage growth acceleration, the Fed’s unwinding of its balance sheet, and a volatile geopolitical milieu. As bricks-and-mortar retail undergoes an epochal transformation, the sector’s risk premium could continue to rise over the near-term. Clarion Partners’ base assumption is that interest rates should remain relatively low for an extended period as forces such as an aging global population, technological disruption, and globalization have been deflationary.

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