September 2017 US Real Estate Summary. Edition 3, 2017 Occupancy rates flattening, leaving rent growth to power income gains Transaction volume still easing off recent highs Cap rates should face slight upward pressure by the end of the year The result: more of the same. Positive returns should continue with lower rates of appreciation
Commercial Real Estate Rent, or more specifically, the importance of continued rent growth, is an increasing theme in our recent US research. With occupancy rates flattening out at levels that vary between good and excellent depending on the property sector, exhibit 1 rent growth is officially the primary driver of propertylevel income in the US. Real estate investors appear to have accepted the normalization back to income-driven performance with relatively little mourning for the days of double-digit core real estate returns. Our positive expectations for the US economy and labor markets imply that there is reason to anticipate income growth will continue to be supported at the property level. Exhibit 1 Occupancy recovery 100 Rate (%) 95 90 85 80 1Q07 3Q08 1Q10 3Q11 1Q13 3Q14 1Q16 Apartments (L) Industrial (L) Office-CBD (L) Office-Sub (L) NCS (L) Hotels (R) Source: CBRE-Econometric Advisors and Axiometrics as of June 2017. Hotel is current through March 2017. NCS is Neighborhood, Community and Strip retail. The US economy grew 2.1% during the first half of 2017 with the repeat of a typical pattern slow first quarter followed by a second quarter bounce-back, exhibit 2. As expected, consumption improved after a slow first quarter, and inventories were no longer a drag on growth. Our Research & Strategy team's Base Case expectation is for real GDP growth of 2.4% for all of 2017. 73 68 63 58 Hotel occupancy rate (%) Exhibit 2 US GDP growth 3.5 Annualized real GDP growth, (%) 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Source: Moody's Analytics as of June 2017. US labor markets continue to strengthen even as it becomes increasingly difficult to maintain the pace of growth. During the first six months of 2017, the US added an average of 180,000 new jobs each month, a similar pace to early 2016. Exhibit 3 shows the unemployment rate declined by 50 basis points (bps) over the past year, implying that there are fewer and fewer unemployed people available to fill openings. Inflation slowed as three of the first six months of 2017 posted small declines, and yet, the current rate of 1.6% for the year ended June 2017 is actually higher than the pace of inflation this time last year. Wages should rise in response to tight labor market conditions, fueling consumption via growth in the demand for goods and services. Exhibit 3 US labor market 350 Thousand jobs 300 250 200 150 100 50 0 Jul-16 3Q16 4Q16 1Q17 2Q17 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Employment (L) 5.0 4.8 4.6 4.4 4.2 4.0 Unemployment rate (R) % Source: Moody's Analytics as of June 2017. 2
With inflation in check and the labor market growing, the Federal Reserve remains in a comfortable position to pursue its on-going strategy of gradually raising the Federal Fund Rate target and beginning to shrink its inflated balance sheet. Income return is driving US real estate performance. During 2Q17, income provided two-thirds of the NCREIF Property Index quarterly total return of 1.75%, representing performance of unlevered properties, exhibit 7. Historically, income provided 70% to 90% of long-term real estate return. Capital growth remains accretive to returns but has decelerated with the transactions market. For the year ended June 2017, total US transaction volume was USD 435 billion (excluding privatizations and REIT mergers), which is 5% below the year-ago level, exhibit 4. The recent slowing in transaction volume is indicative of volume plateauing. During 2014 and 2015, real estate sales volume was growing at rates that were not sustainable. Exhibit 4 US transaction volume 470 Billion USD 460 450 440 430 420 410 15Q4 16Q1 16Q2 16Q3 16Q4 17Q1 17Q2 Rolling four-quarter total (L) Source: Real Capital Analytics as of June 2017. 25 20 15 10 5 0-5 -10 Spreads offered by real estate investments remain near longterm expectations, representing a change from the wide spreads that drew capital so quickly in the wake of the last recession. Shifting from wide spreads back to average spreads gradually removed one of the pressures that had been pushing cap rates lower. Long-term interest rates remain low. After a post-election bump, the 10-year Treasury rate slipped back down and ended the second quarter at 2.31%. As the Federal Reserve put upward pressure on short-term interest rates, the yield curve flattened a little in the first half of 2017. Focusing on the short-end of the yield curve, we expect the Federal Reserve will continue to tighten monetary policy at a modest pace. % Year-over-year growth (R) Real estate debt capital is low cost and generally available, but not free-flowing, as has been the case in the past. Debt markets can be described as operational, but not excessive, which encourages development but not an abundance of supply. Exhibit 5 Construction 2.5 Year-over-year completion rate (%) 2.0 1.5 1.0 0.5 0.0 Apartment Industrial Office Retail 2016 2017 2018 20-year avg Source: CBRE-Econometric Advisors as of June 2017. Exhibit 5 implies that construction is back near normal levels in all but the US retail sector, where shadow supply is difficult to quantify. Even though new development tends to capture more headlines, demand for space should not be forgotten as the other half of the equation. Demand for real estate space should continue to be supported by slow, steady growth in the US economy and a tight labor market. Exhibit 6 implies that there has been enough demand to absorb the supply coming online and still maintain positive rent growth across all property sectors. Exhibit 6 Rent growth trends 10 Year-over-year growth (%) 8 6 4 2 0 1Q15 3Q15 1Q16 3Q16 1Q17 Apartments Industrial Office-CBD Office-Sub NCS Hotels Source: CBRE-Econometric Advisors and Axiometrics as of June 2017. NCS is Neighborhood, Community and Strip retail. Hotel rent is Revenue per Available Room. 3
Property Types Apartments In the apartment sector, new supply weighs on occupancy while demand still supports growth in rents. Vacancy was 5.0% in 2Q17, which is 20 bps above the 2Q16 rate but 80 bps below the 20-year average. Job growth, increasing household formation and low homeownership rates create optimism about continued strong rental demand. Rents grew 2.3% year-over-year. The trend in apartment rent growth has been a gradual slowing in response to rising supply levels and the related increase in concessions. As long as hiring continues and vacancy remains low relative to history, landlords should continue to be able to grow rents in most metros, if less robustly than recent years. Hotels As new hotel construction weighs on the market, it is diffucult to get a feel for the vast range of performance across metros by simply looking at national trends. Some metros had double-digit growth in RevPAR over the past year; others felt double-digit declines. On balance, the hotel sector saw RevPar (Revenue per Available Room) growth slow from 2.7% in the year ended March 2017 to 1.5% in the year ended June 2017. Slightly positive revenue growth is consistent with expectations, as occupancy rates are no longer increasing, leaving room rates to drive RevPAR. Positive economic conditions still support hotel room demand, though we are mindful of changes in the exchange rate and international travel, which may add volatility to the demand forecast. Construction levels should begin to ease toward the end of 2018. Industrial News about a growing need for industrial space is still pretty positive. Industrial rents grew the most of any sector over the last year, adding 6.0%. Demand for consumer goods and e-commerce continues to be favorable. Major international firms have announced plans to open factories in the US. The US industrial sector is facing at least one near-term headwind as sales for US auto manufacturers weakened throughout the first half of 2017. Availability was 7.8% in 2Q17; even though that rate was down 40 bps over the year, it was only down 10 bps in the past three quarters. Supply and demand remain close to equilibrium in the US industrial sector. Office Office-using jobs are being added in the US even though the tight unemployment rate slows down the pace of hiring. Total office vacancy was unchanged from first quarter and up 10 bps since the start of the year at 13.0%. The gap between Downtown vacancy at 10.7% and Suburban vacancy at 14.3% remains wide. Unlike recent years, there is no longer a wide difference in rent growth based on location. Both Downtown and Suburban locations have rent growth close to 3% year-over-year. Retail Positive pressures on consumer spending, including anticipated wage growth and low unemployment, should lead to stronger retail sales growth throughout the balance of 2017. Lifestyle centers and Malls have a 6.0% availability rate, which is down only 100 bps since 2012. Improvement in higher quality properties has likely been offset by deterioration in others. At 10.1%, availability in Neighborhood, Community and Strip center (NCS) retail has been flat since 4Q16. NCS retail posted a 5.9% increase in the year-ended June 2017, which is likely representing a bounce back following a weaker period in 2015 and early 2016, rather than an expectation for a rapid turnaround in retail fundmentals. Supply growth in the US retail sector is not coming from developers, as new construction is well-below 1% of total inventory. New competitive space is coming primarily from the closure of stores and expansion of e-commerce. Owners of physical retail space are adjusting to consumer preferences with high-tech customer loyalty programs driving more traffic to shopping centers where restaurants, movie theaters, and home improvement stores are replacing traditional department store anchors. 5
Viewpoint Compared to the unsustanable high growth rates of 2014 and 2015, US real estate has transitioned to a more typical levels by a number of measures: rent growth, occupancy, transactions and performance. A generally sideways trend in occupancy is likely the result of supply responding to strengthening markets and meeting continued positive demand for space. Demand is supported by growth in the US economy and tight labor markets. Appreciation the market is experencing today generally results from improved income expectations rather than the powerful capital markets effects of the recent past. The gradual leveling off in the sector can be characterized by moderate-to-low vacancy rates, long-term average rent growth, and transaction volume transitioning from huge year-on-year growth to subtle annual declines. In an environment where income is growing across all property types yet is unlikely to accelerate materially, we highlight the virtures of diversifciation and movement toward long-term strategic positioning as reasonable ways to benefit and balance risks. Exhibit 7 Historical performance (%) Total returns (%) 2014 2015 2016 1Q17 2Q17 10-yr 20-yr Bar cap 6.0 0.1 3.0 1.0 1.7 4.3 5.2 S&P 500 13.7 1.4 12.0 6.1 3.1 7.4 7.0 NAREIT 28.0 2.8 8.6 2.5 2.3 6.1 9.1 CPI 0.7 0.7 2.1 0.4 0.0 1.7 2.1 NCREIF Property Index Total 11.8 13.3 8.0 1.5 1.7 6.4 9.7 Income 5.4 5.0 4.8 1.1 1.2 5.6 6.7 Appreciation 6.2 8.0 3.1 0.4 0.6 0.8 2.8 NCREIF total returns by property type Apartments 10.3 12.0 7.3 1.3 1.5 6.2 9.5 Hotel 11.1 13.2 4.7 (0.2) 1.8 4.1 8.1 Industrial 13.4 14.9 12.3 2.8 3.1 7.1 10.1 Office 11.5 12.5 6.2 1.3 1.6 5.5 9.3 Retail 13.1 15.3 9.0 1.6 1.5 8.0 10.7 Source: NCREIF, NAREIT, Bureau of Labor Statistics, Morningstar and Moody's Analytics as of June 2017. Generally good fundamental behavior in the real estate sector gives us some confidence in income expectations, despite pricing uncertainty. Debt capital has avoided excess. Growth in income helps maintain high debt service coverage ratios, relative to ten years ago, with more real income backing mortgage obligations today. US commercial real estate should continue to experience positive performance at a pace that is similar to long-term expectations. 6
Real Estate Research & Strategy US William Hughes Tiffany Gherlone Brandon Best Kurt Edwards Kara Foley Samantha Hartwell Amy Holmes Kim House Brian O'Connell Joshua Rome Laurie Tillinghast Gabriel Zanuttini-Frank For more information please contact UBS Realty Investors LLC 10 State House Square Hartford, CT 06103 Tel. +1-860-616 9000 @UBS www.ubs.com/realestate This publication is not to be construed as a solicitation of an offer to buy or sell any securities or other financial instruments relating to UBS AG or its affiliates in Switzerland, the United States or any other jurisdiction. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith but no responsibility is accepted for any errors or omissions. All such information and opinions are subject to change without notice. Please note that past performance is not a guide to the future. With investment in real estate (via direct investment, closed- or open-end funds) the underlying assets are illiquid, and valuation is a matter of judgment by a valuer. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. A number of the comments in this document are considered forward-looking statements. Actual future results, however, may vary materially. The opinions expressed are a reflection of UBS Asset Management s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Asset Management account, portfolio or fund. Source for all data/charts, if not stated otherwise: UBS Asset Management, Global Real Estate US. The views expressed are as of October 25, 2017 and are a general guide to the views of UBS Asset Management, Global Real Estate US. All information as of June 30, 2017 unless stated otherwise. Published October 25, 2017. Approved for global use. UBS 2017. The key symbol and UBS are among the registered and unregistered trademarks of UBS. Other marks may be trademarks of their respective owners. All rights reserved.