2019 Midyear Market Outlook

Real Estate: The Momentum Continues

Continued economic expansion continues to support
robust opportunities in U.S. commercial real estate.

U.S. Economy

The U.S. economy has maintained surprisingly strong momentum. This expansion cycle is now the longest ever in U.S. history. Consumer spending, a healthy labor market, resilient stock markets, and muted inflation have accelerated growth above consensus expectations. Consensus forecasts for U.S. gross domestic product (GDP) growth for full-year 2019 and 2020 range between 2.0-2.5% — a decent pace, close to the 20-year average of 2.3%, that’s the highest of all major developed markets. However, global growth has begun to moderate relative to recent years, and in select U.S. and EU zones, commercial real estate yields still look compelling on a relative basis in a low interest rate environment. 
The Length of Economic Expansions and Recessions
Source: NBER, Moody’s Analytics, Clarion Partners Investment Research as of May 2019. Each year is the start period for each recession or expansion. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Clarion Partners believes that the slow and steady pace of expansion may in fact prolong the current business cycle and is ideal for real estate investors. Furthermore, most do not anticipate a significant downturn, assuming a relatively stable EU and China in the near term. There is currently no evidence of boom and bust in this expansion cycle. There are, however, tailwinds and headwinds that demand investor attention. 

Tailwinds

  • U.S. Pro-Growth Policy: Tax Cuts and Jobs Act of 2017 (TCJA). Corporate and individual tax reforms have significantly strengthened business and household spending power. 
  • Robust Labor Market and Healthy Consumer Spending: The U.S. unemployment rate is now at an over 50-year low of 3.6%. Job availability is high, and annual wage growth has been over 3.0% for six consecutive months. Most importantly, the labor participation rate for prime age workers (those between 25 to 54) has rebounded significantly. U.S. consumers continue to spend, with year-over-year total retail sales up 2.7% in Q1 2019. 
  • Dovish Fed: Key borrowing rates have moderated with the Fed’s most recent announcement that there are likely to be no further rate increases in 2019. The outlook for U.S. credit conditions is stable in the near term. Because U.S. inflationary pressure is low, the Fed may have room to cut interest rates, if necessary.
  • Energy Independence: Domestic oil and natural gas production levels are at record highs. U.S. energy independence is a key differentiator, and the U.S. is now on track to become a net oil exporter by 2020. Furthermore, energy prices are generally low, boosting U.S. consumers' discretionary spending. 

Headwinds

  • Shifting Trade Dynamics. Global trade will likely be impacted to some extent by the new and ongoing global protectionist trade agreements. The signing of the trilateral United-States-Mexico-Canada Agreement (USMCA) will likely boost near- and on-shoring activity. However, U.S.- China trade tensions have escalated recently.
  • Global Economic and Political Uncertainties:  Globally, monetary stimulus programs are still under way at many central banks worldwide, which are expected to keep rates low, as balance sheets are gradually paid down. Within the EU, bank rates are largely negative, therefore, the U.S. has a significant yield advantage. A final Brexit deal and any more serious slowdown in China could lead to some political and trade instability in the EU and Asia, which might have broad-reaching impacts.
  • High Corporate and Government Debt Levels:  A record level of U.S. corporate debt is now viewed as another potential risk; however, corporate profits still look very strong. At the same time, the U.S. debt-to-GDP ratio is also at a record high.

The U.S. Real Estate Market

Overall, Clarion Partners maintains a cautiously optimistic outlook for U.S. commercial real estate in 2019 and 2020. In most U.S. markets, occupancy rates are now at 90-95%, and annual same-store net operating income (SS NOI) is well above the long-term average, at about 2.6%.

Attractive total returns will be driven by low availability and still accretive financing. There are plenty of opportunities to obtain and create value through select investment strategies. Outperforming themes will likely include socioeconomic diversity, urbanization, age-specific demands, low tax states, and high-growth industry clusters (e.g., high-tech and life sciences). The global search for yield will likely continue to benefit the U.S. real estate investment market and lead to a super-long cycle.

Nationally, a positive macro environment and healthy property fundamentals have supported solid investment performance for privately held U.S. commercial real estate (CRE) investment performance. Nearly 10 years into this cycle, the CRE sector has continued to offer steady income and good portfolio diversification. Most property sectors (excluding retail) report an ongoing rise in occupancies, rents and asset values. Globally, institutional investor allocations to this asset class have been rising steadily. The U.S. remains the top safe haven for foreign capital, and cap rates have remained attractive on a relative basis. A solid economic backdrop will likely continue to benefit supply/demand fundamentals:
  • Household Formation Well Above Long-Term Average. In both 2019 to 2020, annual household formation is set to grow well above the long-term average of 1.2 million, and a whopping 6.5 million from 2019-2023.
  • Steady Job Growth. Year to date, average annual job gains were 2.6 million, well above the long-term average, with accelerating wage growth and high job availability.
  • Millennials Entering Peak Spending Years. The eldest Millennials have now entered peak spending years. Consumer spending is viewed as the primary engine of economic growth, and it's expected to hold steady.
  • Elevated Cross-Border Capital Inflows. Foreign inbound investments have generally continued to rise to record levels, which has improved overall liquidity and created greater competition/pricing for high-quality properties.
  • Solid Investment Performance. The NCREIF Property Index (core unlevered) returned 6.8% year over year as of Q1 2019. The industrial sector and West Coast outperformed by a large margin.
These factors should generate steady new demand and rent growth for commercial and residential space. Other tailwinds for future asset appreciation are rising construction prices, labor costs and a shortage of land availability, which have significantly mitigated new construction and escalated replacement costs. New-supply levels remain near historic lows (except for a few select markets/submarkets), however, we recommend mainly build-to-core acquisitions being highly-selective on more opportunist transactions.

In the near term, Clarion generally favors industrial, multifamily, and central business district (CBD) office spaces connected to tech, new media, and health care related industries in major CBDs, premier suburban submarkets, and top secondary markets. We expect sustained investor interest in supply-chain logistics, rental housing, non-traditional workspaces, leisure & hospitality destinations and medical properties.  
2019 Midyear Outlooks
Brandywine Global
Growth: Turning a Corner
Clarion Partners
The Momentum Continues
ClearBridge
Cautious Optimism for Equities
EnTrust Global
Realistic About Risk
Martin Currie
Looking Beyond the U.S.
QS Investors
Where Do We Go from Here?
RARE Infrastructure
U.S.-China: Fallout from Trade Tensions?
Royce & Associates
Cyclical Thinking
Western Asset
Resilient Growth, Despite Uncertainty

Investment risks:

Investment in real estate entails significant risks and is suitable only for certain investors as part of an overall diversified investment strategy and only for investors able to withstand a total loss of investment.

Yields and dividends represent past performance, and there is no guarantee they will continue to be paid.

Outperformance does not imply positive results.  
 

Definitions:

The Tax Cuts and Jobs Act (TCJA) of 2017 is a congressional revenue act of the United States that amended the Internal Revenue Code of 1986. Major elements of the changes include reducing tax rates for businesses and individuals; a personal tax simplification by increasing the standard deduction and family tax credits, but eliminating personal exemptions and making it less beneficial to itemize deductions; limiting deductions for state and local income taxes (SALT) and property taxes; further limiting the mortgage interest deduction; reducing the alternative minimum tax for individuals and eliminating it for corporations; reducing the number of estates impacted by the estate tax; and repealing the individual mandate of the Affordable Care Act (ACA).

The agreement between the United States of America, the United Mexican States, and Canada is a signed but not ratified free trade agreement between Canada, Mexico and the United States. It is referred to differently by each signatory—in the United States, it is called the United States–Mexico–Canada Agreement (USMCA); in Canada, it is officially known as the Canada–United States–Mexico Agreement (CUSMA) in English and the Accord Canada–États-Unis–Mexique (ACEUM) in French; and in Mexico, it is called the Tratado entre México, Estados Unidos y Canadá (T-MEC). The agreement is sometimes referred to as "New NAFTA"in reference to the previous trilateral agreement it is meant to supersede, the North American Free Trade Agreement (NAFTA).

The NCREIF Property Index (NPI) provides returns for institutional grade real estate held in a fiduciary environment in the United States. Properties are managed by investment fiduciaries on behalf of tax-exempt pension funds. As of the second quarter of 2003 the index contains 3,967 properties with an aggregate market value of $127 billion. The objective of the NCREIF Property Index (NPI) is to provide a historical measurement of property-level returns to increase the understanding of, and lend credibility to, real estate as an institutional investment asset class.

Gross Domestic Product (GDP) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

The Federal Reserve Board (“Fed”) is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

"Brexit" is a shorthand term referring to the UK vote to exit the European Union.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

Important Information

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

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Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

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