GENERAL ECONOMIC OVERVIEW The U.S. is increasingly one of the few bright spots of the global economy. Preliminary estimates of thirdquarter GDP growth show an annualized gain of 3.5%, well ahead of expectations. The U.S. is increasingly one of the few bright spots of the global economy. Preliminary estimates of third-quarter GDP growth show an annualized gain of 3.5%, well ahead of expectations. Following 4.6% annualized growth during the second quarter this represents the strongest six-month growth in the U.S. economy since the end of 2003. More significantly, the U.S. is now well into the expansion phase of the economic cycle in terms of employment. The U.S. economy lost more than 8.7 million jobs between January 2008 and February 2010, a decline of more than 6% of total employment. As of September 2014, total employment in the U.S. stands at more than one million above the pre-crisis peak and job growth is accelerating. Over the past six months, total employment in the U.S. has increased by an average of 245,000 per month, the strongest job growth of the recovery so far. Additionally, average monthly gains during 2014 are now the strongest of any year this century. Additionally, the unemployment rate, a key indicator for consumer sentiment and monetary policy, dropped below 6% in September, again the first time the rate has been below 6% since the onset of the economic downturn. In contrast to the U.S., recent data show slowing growth across Europe, China and Japan prompting the International Monetary Fund (IMF) to lower its global growth expectations for 2015. In response to slowing global growth, oil prices have dropped considerably with the West Texas Intermediate benchmark falling from more than $100 per barrel in early September to less than $80 per barrel in early November, with additional declines likely. In turn, core consumer price inflation has eased as well, advancing 1.7% on a year-over-year basis in September, down from a 2.0% rate in May. Despite increasing concerns over global growth and slowing inflation, the Federal Reserve appears to remain on pace toward normalizing the extraordinary monetary policies that were implemented to mitigate the effects of the financial crisis. At their most recent meeting, the FOMC reiterated their intention to keep interest rates low for a considerable time. The FOMC also confirmed the end of its asset purchase program (Quantitative Easing), an important first step in the normalization of monetary policy that is likely to take place over the next several years. We expect
Overall, we expect this dynamic to remain in force over the next several years. A rising U.S. dollar coupled with an improving U.S. economy should spur broader growth in demand for U.S. property. that the Fed will stay true to their current plan and will begin raising shortterm interest rates by mid-2015. The impact of this more conventional form of tightening is likely to further strengthen the U.S. dollar and provide an additional boost to the recovering U.S. consumer sector. The impact of higher short rates on the yield curve remains unclear. Currently, strong capital flows from abroad, largely in response to falling yields elsewhere, are putting strong downward pressure on the long rates in the U.S., and this downward pressure is spilling over into U.S. property yields. Overall, we expect this dynamic to remain in force over the next several years. A rising U.S. dollar coupled with an improving U.S. economy should spur broader growth in demand for U.S. property. These same conditions should also lead to continued strong capital flows into the U.S., dampening any pressures toward higher interest rates and property capitalization rates. AEW Research still anticipates an eventual increase in average cap rates of roughly 50-100 basis points over the next three to five years. This increase would necessitate an average increase in NOI of roughly 15% given the current NCREIF average capitalization rate of 5%, in order to offset the effect of higher property yields. Fortunately, most U.S. property markets are poised for healthy near-term rent growth as total employment moves well above prior peaks creating demand for additional commercial space and, ultimately, the need for additional new supply. All of which, we believe, will offset most, if not all, of the impact of any near-term cap rate expansion. REAL ESTATE REVIEW Key Real Estate Indicators Property Type Vacancy Rates Rents Absorption Completions Cap Rates Transaction Volume Office 14.1% Industrial 10.8% Retail 11.5% Multifamily 4.3% Seniors Housing 9.7% Higher Lower No Significant Change Source: CBRE-EA, NIC, NCREIF, RCA, NICMAP Note: The arrows reflect the trend for the 12 months ending in Q3 2014 compared with the comparable period for 2013 for rents, absorption, completions and transaction volumes; and current quarter versus year ago for vacancy rates and cap rates. For vacancy rates, a down arrow indicates declining vacancy rates or an improvement in market fundamentals. For cap rates, a down arrow indicates falling cap rates or rising prices. INDUSTRIAL U.S. property markets are primed for a continued healthy recovery. Vacancies across all property types moved lower in the third quarter. The industrial market is showing considerable strength with vacancies dropping 110 basis points over the previous 2
four quarters to 10.8% in the third quarter of 2014. The third quarter marked the first time vacancies fell below 11% since 2007. Demand continues to run at a pace that is twice that of deliveries with net absorption of over 60 million square feet in the third quarter. Further, CoStar Portfolio Strategy reported a pickup in small tenant demand, a segment that had been on the sidelines to date. There were differences, however, in industrial availability based on square footage, with the lowest availability reported among the smallest (10,000 to 49,000 square feet) and largest segments (over 400,0000 square feet) at 9.1% and 10.6%, respectively. Availability was greatest within the 200,000 to 399,000-square-foot segment of the market at 12.0%. Going forward, there may be opportunities to subdivide buildings in this size range to capture the improving demand from small tenants. The continued reshoring of manufacturing to the U.S. has had a favorable impact on demand for manufacturing space. Year-to-date, nearly 17 million square feet of manufacturing space has been absorbed, more than double the completions. Manufacturing availability declined to 8.8% in the third quarter, the lowest level since 2008. Midwestern and southeastern markets, in particular, are benefitting from the resurgence in manufacturing and this is seen in the above-average decline in manufacturing space availability in Memphis, Gary, Detroit, Akron, Raleigh, Charlotte, Indianapolis, St. Louis, Chicago, and Kansas City. Together, these markets have accounted for roughly 57% of the nearly 70 million square feet of manufacturing space absorbed since mid-2010. Going forward, a recovery in the housing market will likely aid many of these industrial markets as they tend to be home to appliance and construction material manufacturers. More broadly, the ongoing U.S. economic expansion should continue to foster demand for all industrial space. Meanwhile, supply, which has largely remained in check, is projected to pick up. Still, availability is projected to near 10%, allowing for continued healthy rent growth in the sector. Markets poised for particularly healthy near-term rent growth include Southern California, Atlanta, Austin, the East Bay, Cincinnati and Indianapolis. OFFICE Meanwhile, vacancies in the office market declined by 40 basis points to 14.1% in the third quarter; this was the largest quarterly reduction in vacancies since the recovery began. Overall, office vacancies are down 270 basis points from peak, however, the improvement in fundamentals remains skewed to Class A product. Vacancies in Class A office declined by 40 basis points to 12.9% and are down 340 basis points from peak. Class B/C vacancies declined by 20 basis points to 15.9%, down 200 basis points from peak. The spread between Class A and Class B/C vacancies, which had narrowed to 270 basis points in the first quarter, has reversed course and expanded to 300 basis points. According to CoStar Portfolio Strategy, demand among 4- and 5-star buildings accounts for over 50% of total net absorption 3
over the previous four quarters, well above this subsector s 34% of inventory. Regionally, Raleigh, San Francisco, Pittsburgh, New York, Houston, Charlotte, Austin, Boston, Nashville and Philadelphia reported Class A downtown vacancies below 10% and Class A suburban vacancies below 12%. These compare favorably to the U.S. average of 10.8% and 14.5% among downtown and suburban markets, respectively. A strong health care, high tech or energy presence is driving the demand in these markets. The combination of improving occupancies and higher rents should lead to substantial NOI growth, which should offset any cap rate expansion. Going forward, supply is expected to increase, but will remain concentrated in select markets, including San Jose, Houston, Austin, San Francisco, Seattle and Dallas- Fort Worth. Over 7.3 million square feet of office space is currently underway in San Jose, representing 18.1% of existing inventory. Meanwhile, 17 million square feet or 11.2% of inventory is underway in Houston. Pre-leasing among the markets with the greatest projected supply is strong. For example, in San Jose and Houston over 70% of the space under construction is pre-leased, while most of the remaining markets have pre-leasing of over 60%. Further, AEW Research determined the bulk of new supply underway in San Jose and Houston, in particular, represents net new demand. The only market in which supply may be a concern to date is Austin, where pre-leasing totals 36%. Thus, with limited new available supply and solid demand, the office sector has strong prospects for improving fundamentals and healthy rent gains. The office sector is in a particularly good position to capture sizeable rent gains as leases signed in the depths of the recession roll to higher rents. The combination of improving occupancies and higher rents should lead to substantial NOI growth, which should offset any cap rate expansion. RETAIL The retail sector remains a laggard in the ongoing property market recovery. Vacancies have continued to improve, but at a modest pace. According to preliminary estimates from CBRE-EA, vacancies declined by 20 basis points to 11.5% in the third quarter. Retail vacancies are currently 170 basis points below their cyclical high of 13.2%, the smallest improvement in vacancies among the four core property types. Consumer spending has been restrained due to modest income growth. With gasoline prices moving lower, however, consumers may soon have an unanticipated bump in discretionary income. Lower gas prices, coupled with rising home prices and improving consumer confidence, suggest year-end sales should be better than last year. Over the long term, continued employment growth should eventually generate better income growth and lend support to the retail sales. That said, the impact of increased sales on retail property market fundamentals may be somewhat muted. E-commerce sales continue to grow at a year-over-year pace that is three to four times higher than retail sales growth, which could affect demand for space and lead to a slower more protracted decline in vacancies. This development, along with the long leases in the retail sector, may limit the ability to push rents and ultimately hinder NOI growth. 4
Household formation is picking up and right now it does not look like supply will keep up with this demand; so the runway for rent growth looks fairly long. MULTIFAMILY Lastly, the apartment market remains a shining star among the four main property types. Vacancies remain low, dropping to 4.3% in the third quarter from 4.4% in the prior quarter. While the increase in multifamily development has raised eyebrows and prompted a proliferation of discussions about the subject, to date it is not adversely affecting the market. Indeed, in mid-september, the Wall Street Journal noted that apartment construction hit its highest level since 1989. AEW Research certainly does not refute the fact that construction has grown substantially, but we try to look at the construction activity in context. First, we are coming off of several years of very low levels of development. In the 15 years leading up to the economic downturn, institutional-quality multifamily stock, as tracked by MPF & CBRE-EA, increased an average of 1.5% a year. From 2010 through 2012, the average annual increase in stock dropped to 0.5%, meaning that 400,000 fewer multifamily units came online during that period than would have under normal circumstances. The 2013 deliveries were not excessively high and totaled 1.5% of inventory, in line with the average. Also, the units currently underway total only 1.6% of inventory. Both of these are normal development years; meaning the market has yet to fill the 400,000-unit void from the downturn. On the demand side, household formation was lower during the downturn, but demand for apartments recovered quickly as many homeowners became renters. Today, as a result, we have exceptionally low vacancies across many markets. Household formation is picking up and right now it does not look like supply will keep up with this demand; so the runway for rent growth looks fairly long. While there may be differences by market and submarket, apartment fundamentals should remain tight in the coming years. SENIORS HOUSING The seniors housing market continued to fire on all cylinders in the third quarter as the underlying fundamentals improved and investor appetite supported a liquid transaction market. Occupancies moved above the 90% mark in the third quarter to 90.3%, up 40 basis points over the quarter and 100 basis points from year-ago levels, which was particularly encouraging given the number of units that came online. Supply growth bumped up to an annual pace of 1.7% in the third quarter, which is still well below the cyclical peak of 2.8% before the great recession took hold. Despite the increase, demand continued to outpace supply by a healthy margin expanding 2.9% over the past 12 months versus the 2.6% pace last quarter. After a modest 10-basis-point decline in occupancies last quarter, the majority assisted living (AL) properties regained their positive momentum. In the third quarter, occupancy increased 50 basis points to 89.4%, which is within 90 basis points of pre-recession peak levels. Demand for AL units has been consistently strong throughout the recovery with a more notable acceleration over the past two years. The solid performance of the sector during the recession and the recovery is primarily because demand for AL is more needs-based than demand for independent living. Meanwhile, the acceleration in economic growth over the past 5
DID YOU KNOW? Investment themes we are observing in the market today New Congressional Budget Office projections show rapidly improving U.S. deficit position in the near term; longer term, social security will be a net drain, reversing this improvement. Prior to 2008, there was no clear relationship between the size of the Fed s balance sheet and asset values. Since 2008, there has been a strong positive correlation. Inflation expectations have been falling for the past 30 years. Lower inflation, lower risk premia and higher equity risk have combined to lower required real yields. At $35.7 billion, global direct capital inflows to U.S. real estate in the first half of 2014 nearly match 2013 s annual total of $37.9 billion. Prepared by AEW Research, This material is intended for information purposes only and does not constitute investment advice or a recommendation. The information and opinions contained in the material have been compiled or arrived at based upon information obtained from sources believed to be reliable, but we do not guarantee its accuracy, completeness or fairness. Opinions expressed reflect prevailing market conditions and are subject to change. Neither this material, nor any of its contents, may be used for any purpose without the consent and knowledge of AEW. AEW Two Seaport Lane Boston, MA 02210 +1 617 261 9000 www.aew.com year is helping the more discretionary independent living sector as well. Average occupancy rates for majority independent living (IL) properties climbed 40 basis points to 90.9% in the third quarter and are up over 140 basis points over the past 12 months. The solid performance across all property types is showing up in investment returns. Total returns for real estate remained strong this quarter, with the NPI producing a one-year return of 11.26%. The return was almost evenly split between income at 5.41% and appreciation at 5.62%. Among the four core property types, industrial and retail yielded the strongest total returns at 12.39% and 13.09%, respectively. The outperformance of industrial and retail was largely the result of stronger appreciation gains in both sectors. Solid appreciation returns across property types have been supported by strong capital flows coming into the real estate sector. According to Real Capital Analytics (RCA), nearly $102 billion in properties changed hands in the third quarter of 2014, an 11% increase in volume from a year earlier, driven primarily by gains in apartment and office transaction volumes. Across all property types, however, sales of portfolios moderated while individual property sales were solid. Apartment volume totaled $27.5 billion, up 28% from a year earlier. Individual apartment property sales ranked as the third highest on record, making up for a slowdown in portfolio sales. Meanwhile, roughly $30.6 billion in office properties changed hands, up 22% from a year earlier; CBD volumes were up nearly 40% while suburban volumes were up 5%. On the retail side, sales of individual properties were also strong, but not enough to offset the decline in portfolio sales. Additionally, only one regional mall, Pacific Place in Seattle, changed hands in the quarter. The absence of additional mall transactions held back overall retail volumes, which stood at $18.3 billion as of the end of the third quarter, down 8% year-over-year. Finally, industrial sales totaled $12.5 billion, down 13% year-over-year. Warehouse volume contributed $8.0 billion in transactions volume to the overall industrial total, but this was down 22% year-over-year; again, less portfolio activity was the reason for the decline in total warehouse volumes. Not surprisingly, cap rates have remained low. Again, capital flowing to the sector has been strong, supported by favorable fundamentals and good relative performance, which has continued to exert downward pressure on cap rates. According to NCREIF, apartment cap rates remained lowest at 5.0% in the third quarter, down 10 basis points from the previous quarter and 10 basis points yearover-year. In Q3, office and industrial cap rates were both down 10 basis points for the quarter and year-over-year, at 5.4% and 5.8%, respectively. Meanwhile, retail cap rates were flat in the quarter at 5.8%, but were down from 6.1% a year earlier. 6