U.S. commercial real estate: Q review and outlook

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1 U.S. commercial real estate: Q3 218 review and outlook Real Estate Team, Private Markets, Manulife Asset Management November 218

2 United States: as good as it gets The U.S. economy remains the leader among developed countries, with Q3 218 GDP growth coming in at 3.5%, driven by consumer spending, inventory buildup, and government spending. 1 As the positive effects of the tax cuts introduced earlier in the year continue to trickle through, some economists expect the U.S. economy to grow by 3.% this year, a rate not seen since 2. 2 The labor market remains tight, with unemployment at 3.7% the lowest level since December 199 and wages continuing to slowly tick higher. 3 Given continued demand for labor, we can expect wages to continue to rise. These improved conditions have driven consumer confidence the Conference Board s Consumer Confidence Index is hovering near an 18-year high. The recently agreed U.S.-Mexico-Canada Agreement (USMCA), which is set to replace NAFTA, represents progress on trade. It s been suggested that U.S. firms have delayed investment decisions due to a lack of visibility while the negotiations were taking place, and that agreement is likely to change that. In our view, however, the real threat to U.S. growth was and continues to be the risk of a full-blown trade war with China. Strong economic data and hawkish comments from the U.S. Federal Reserve (Fed) have contributed to the recent rise in bond yields, which led to a global sell-off in equities as the markets reprice term premiums. Our Global Chief Economist Megan E. Greene expects the Fed to raise rates three times between now and the end of 219: once in December and twice next year. While she doesn t expect a recession to take place in 219, she believes investors should monitor several issues that could hurt growth among them, the ongoing trade dispute between Washington and Beijing, the level of nonfinancial corporate debt, and how the strength of the U.S. dollar could hurt emerging-market economies. Average hourly wage growth (%) Unemployment (%) Source: U.S. Bureau of Labor Statistics, as of September 3, 218. Source: U.S. Bureau of Labor Statistics, as of September 3, U.S. Bureau of Economic Analysis, advance estimate, as of October 2, The Conference Board, as of October 1, U.S. Bureau of Labor Statistics, September 218. Federal Reserve Bank of New York, as of October THIS MATERIAL IS FOR INSTITUTIONAL/PROFESSIONAL USE ONLY.

3 Real estate market outlook, Q Investment markets are stabilizing Following two years of shrinking volumes, U.S. investment markets are showing signs of stabilization so far in 218, with industrial and multiresidential segments leading the growth. Preliminary data suggests that Q3 218 will mark the third quarter of consecutive year-over-year (YoY) growth. While portfolio and entity-level transactions account for most of this growth, individual asset acquisitions have also remained healthy. So far this year, most investor groups have increased their activities, except for public real estate investment trusts. For the first half of 218, foreign and institutional investors experienced the strongest YoY growth of 27% and 13%, respectively. The yield difference between private and public real estate markets is the primary reason for weak acquisition activity by public market investors, who ve been a net seller in recent years. These figures mask the divergence in trends between property types, however. The office market is on an upswing, with Q3 218 volumes increasing by 12% YoY after four consecutive quarters of YoY negative growth. This recent positive performance is primarily the result of a turnaround in central business district (CBD) office sales. Income growth opportunities in industrial and multiresidential continue to attract investors, with industrial reaching a record high annual volume of US$81 billion, and multiresidential on pace to hit the record high annual volume of US$159 billion seen back in 21. Asset pricing trends have remained relatively flat across most property types in 218, except for industrial, where cap rates compressed 1 basis points (bps) through Q As a result of the interplay between increasing transaction volumes and rising interest rates, we expect yields to remain stable in the medium term. Quarterly transaction volume, YoY growth Volume, YoY (%) Q2 1 Q3 1 Q 1 Q1 15 Q2 15 Q3 15 Q 15 Q1 1 Q2 1 Q3 1 Q 1 Q1 17 Q3 17 Q 17 Q1 18 Q3 18* Quarterly volume, YoY change Total volume, trailing 12 months Source: Real Capital Analytics, as of October 2, 218. * Preliminary data. Transaction cap rate, 12-month average (%) Transaction cap rate Q2 Q2 7 Q2 8 Office Industrial Q2 9 Q2 1 Q2 11 Q2 12 Q2 13 Q2 1 Retail Apartment Q2 15 Q2 1 Source: Real Capital Analytics, as of October 2, Volume ($) 5 All market fundamental statistics, including vacancy, absorption, completion, under-construction, and rent growth, are sourced from CoStar, as of Q All capital market statistics, including transaction volume, cap rates, and price index, are sourced from Real Capital Analytics, as of Q THIS MATERIAL IS FOR INSTITUTIONAL/PROFESSIONAL USE ONLY.

4 Office markets see uptick in demand In line with recent economic growth, demand for office space has ticked up. Net absorption exceeded completions by 1 million square feet (SF) in Q3 218, the highest over the past two years, resulting in a decline in the average vacancy by 1bps to 9.8%. Recent employment data is indicative of healthy economic expansion and supportive of demand for office space. Total nonfarm employment in 218 increased by 1.7 million through August, an increase of 9% YoY. 7 With job openings standing at a record high of 7.1 million, 8 employment growth is expected to remain robust in the medium term. With the unemployment rate for educated labor at a near historic low of 2% 9 and baby boomers beginning to exit the workforce, the availability of educated labor will be the major limiting factor for growth over the next decade. Naturally, markets with higher growth in their working-age educated population are likely to attract employers and experience stronger demand fundamentals. Furthermore, as labor markets tighten, the quality of office space will likely become an increasingly important factor for attracting and retaining talent. Accordingly, we would expect well located high quality assets to capture a disproportionately high share of demand. Average rent growth has continued to decline since its peak in 215, but seems to be stabilizing more recently. Average annual rent growth in Q3 218 was 2.%, down by 1bps quarter over quarter. There s also considerable divergence among markets, with Southern and lower-cost Western markets leading the rent growth. Construction activity appears to have peaked in 217, and with rent growth, inflation, and interest-rate trends not supportive of increased activity, we expect new construction to continue to trend down. New York, Washington, Dallas, Chicago, and San Francisco are the top five markets with the most construction. Office supply/demand fundamentals SF (millions) Q 1 Q1 17 Q3 17 Net absorption Net completion Vacancy Q 17 Q1 18 Source: CoStar, as of October 2, 218. Office 12-month rent growth (%) Rent growth Source: CoStar, as of October 2, Q3 18 Office under construction as % of stock Under construction (%) Vacancy (%) Source: CoStar, as of October 2, 218. U.S. market is defined as the top 5 markets that CoStar Portfolio Advisory tracks for national trends analysis. 7 U.S. Bureau of Labor Statistics, preliminary employment estimate, August U.S. Bureau of Labor Statistics, August U.S. Bureau of Labor Statistics, August 218. Educated labor is defined as holding a bachelor s degree or higher. THIS MATERIAL IS FOR INSTITUTIONAL/PROFESSIONAL USE ONLY.

5 Demand in industrial markets outguns GDP Demand for industrial space continues to outpace overall economic growth as logistics infrastructures adapt to requirements of e-commerce. Industrial net absorption of 55 million SF against net completion of 53 million SF in Q3 218 helped push vacancies to.7%, another historic low over the past 35 years. Historically, industrial sector demand had a one-to-one relationship with overall economic growth; however, in recent years, demand has accelerated to 1.3 x GDP. This additional appetite can be primarily attributed to the needs of e-commerce companies for large regional and superregional warehouses and small, last-mile fulfillment centers. These unexpectedly high demand fundamentals paired with slow supply response earlier in the cycle have resulted in strong occupancy gains in recent years. Rent growth has also accelerated in recent years to a historically high rate of near %. Although rent growth has edged down over the past six months, the market doesn t appear to be peaking anytime soon, with rents forecast to continue to grow in most markets through the end of 222. With peak pricing, construction activity has continued to rise, surpassing the prior peak. As a result of increased supply, most markets are forecast to reach equilibrium by next year for bulk regional products. However, given physical constraints for development of last-mile and infill/local products, we expect continued occupancy and stronger rent growth fundamentals in those segments. Industrial supply/demand fundamentals SF (millions) Q 1 Q1 17 Net absorption Net completion Vacancy Q3 17 Q 17 Source: CoStar, as of October 2, 218. Q1 18 Industrial 12-month rent growth (%) Rent growth Source: CoStar, as of October 2, Q Industrial, under construction as % of stock 5 Vacancy (%) 218 Under construction (%) Source: CoStar, as of October 2, THIS MATERIAL IS FOR INSTITUTIONAL/PROFESSIONAL USE ONLY.

6 Multiresidential markets benefit from housing shortage Demand for multiresidential enjoys strong fundamentals based on demographics and an overall shortage in housing. With net absorption of 72, units and net completion of 58, units, average vacancy rates reached 5.7% in Q Despite increased supply in recent years, overall U.S. housing markets remain undersupplied. To meet the demand for new household formation and the replacement of old units, some 1. million housing units per year were needed over the last seven years; however, total completions of single-family and multifamily averaged less than 1. million units per year. Furthermore, economic and lifestyle factors supportive of renting continue to strengthen. The lifestyle factors include increasing median age of marriage and the percentage of people living alone, and the economic factors include a ballooning student debt and weak wage growth during the current economic cycle, which has eroded affordability of home ownership. The overall strength of fundamentals is also evidenced in rent growth, which continues to trend up. Average rent growth stood at 3.2% for the 12 months ended September 3, 218. However, this growth isn t uniform across different segments, with higher-end products in core CBD markets experiencing flatto-declining net effective rent growth. Construction activity continues to trend up, with 53, units under construction equivalent to.5% of existing stock. However, construction activity is relatively concentrated in major markets, with the top 1 markets accounting for half of total construction activities. Multiresidential, supply/demand fundamentals Thousand units Q 1 Q1 17 Net absorption Net completion Vacancy Q3 17 Q 17 Source: CoStar, as of October 2, 218. Q1 18 Multiresidential, 12-month rent growth (%) Rent growth Source: CoStar, as of October 2, Q Multiresidential, under construction as % of stock Under construction (%) Vacancy (%) Source: CoStar, as of October 2, 218. THIS MATERIAL IS FOR INSTITUTIONAL/PROFESSIONAL USE ONLY.

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