What better port in the current storm? Michael Cohen assesses the attractiveness of the US for global investors on a sector-by-sector basis
A recent steady stream of discouraging economic data and the threat of a debt crises on both sides of the Atlantic have thrown up some headwinds — perhaps even gale force winds — against a more sanguine outlook for US commercial real estate.
Certainly, an investor's perspective on both economic and capital market conditions creates a prism through which opportunities (or risk) in the US are viewed. But despite macro uncertainties and speculation about the increased risk of recession - which is not Property & Portfolio Research's (PPR) base case - the sheer size, transparency, and liquidity of the US market continue to attract global capital, as evidenced by $100bn (€69.4bn) in transactions in 1H 2011.
And the economic news in the US is not all bad: employment growth remains positive (albeit moderate); most large banks have met with success in recapitalising their balance sheets, and the US consumer is still shopping. Any investment thesis for the US, however, requires a sophisticated understanding of key geographical employment drivers, shifting population/workforce demographics, and supply/demand characteristics across property types. In other words: market and property type selection matters more than ever.
Of the four core US property types, the multifamily rental market has demonstrated the most pronounced recovery in fundamentals. Following a cyclical (and historical) vacancy high of 8.3% at the close of 2009, multifamily vacancies across the 54 largest metros in the US (the ‘PPR54') have plummeted to under 7%, against a steady drop in US home-ownership. Unlike the case in Germany, 66% of US households own their home. But the sharp drop in US home-ownership since mid-2004 has propelled the total number of rental households to near a historical 40 million. Moreover, after a decade of below-average overall household formation, the US is poised to experience stronger organic growth due in large part to the demographic tailwind of the sizable ‘echo boom' generation (about 75m) reaching adulthood.
The outlook for US multifamily remains favourable, with total transaction volume of almost $67bn since the beginning of 2010. But given multifamily's present popularity with investors, cap rates have plummeted, as pricing has heated up. While most cities in the US are benefitting from a cyclical shift towards renting, issues are arising. First, given the dearth of new product coming to market, coupled with frothy pricing on the acquisitions front, investors are increasingly redirecting their equity towards new construction, as shown by the recent pickup in multifamily starts. Secondly, not all cities in the US share the same favourable demographic trends noted above.
The recovery in the US office market has been less pronounced. After accelerating through 2010, office absorption hit the skids during the first half of 2011, and even with new construction near record lows, the national vacancy rate (as measured by the PPR54) fell only slightly, to 18.5%. Overall, this cycle's vacancy recovery should roughly resemble that in the 2004-07 period, and overall absorption will be weaker both during the early phase of this recovery and at its apex. But with the financial industry wounded going into this recovery, construction finance will probably be much more limited, resulting in less office construction. The key difference this time around is that vacancies are falling from a higher peak. As a result, they will take longer to fall into comfortable territory.
The next five years should be particularly class-A friendly, but this segment of the US office market is by no means home free. Thanks mostly to new construction, class-A vacancies ran up further than those in the B market during the last recession. However, while class-B vacancies in the US have remained flat since they peaked in 2010, class-A vacancies have fallen 70bps from their mid-2010 peak. There was more demand for class-A properties than for class-B properties during 2003-07 and continues to be so during the recovery. The much greater levels of new construction in the class-A market's is a weakness. But with deliveries near record lows and supply growth expected to remain historically low through 2015, class-A fundamentals should continue to show the strongest improvements.
On the retail front, economic vacancies continue to tighten, because fundamentals took another big step towards normalcy in the second quarter. Demand, while squeezed in the second quarter by economic woes, is up significantly over levels seen 12 months ago. And some retailers are even increasing profits thanks to a reduction in competition. As a result, economic vacancies keep receding and tenancy is becoming more stable. This trend will only accelerate as the economy shakes off the mid-year slump. But there is still a long way to go before landlords can reclaim bargaining power here.
Physical vacancies are falling across all retail product types. But, importantly, ‘power centres' (home of the likes of Wal-Mart and Target) are leading the pack. Since the end of 2009, power centre vacancies have fallen about one percentage point compared to a 30bps drop for all retail. Power centres have outperformed the market in terms of absorption in every year since 2006, even remaining positive throughout the recession. However, vacancies trended up because of an aggressive delivery schedule. Now that supply growth has faded, the centres' outsized demand growth has significantly reduced vacancies.
Finally, the US warehouse/distribution market is improving as retail sales, manufacturing output and trade keep strengthening, albeit at a slower pace. Leasing continues to be driven by retailers and third-party logistics firms, both favouring absorption in large, modern product. Modest demand growth and deliveries, which are probably at a cyclical low, brought warehouse vacancies down for the fifth consecutive quarter as of mid-2011. Most industrial indicators have improved markedly in the past year; however, recent leasing activity has been lackluster.
There are a few likely culprits. The economic events that weakened growth in the first half of the year could continue to hold demand back in the near term (GDP growth is about 72% correlated with warehouse demand nationally, with a one-quarter lag). Shadow supply is absorbing growth that would have otherwise created new net absorption. And housing starts (about 63% correlated with warehouse demand nationally, with a lag of two quarters) remain oppressively low. Ultimately, economic expansion will result in a quickening of warehouse absorption. Deliveries are expected to inch up in the near term but should remain low relative to history until warehouse rents grow significantly next year, giving developers the green light to build.
The US is not a single, homogenous marketplace: to invest there successfully overseas investors may need to move outside their geographic comfort zone (the ‘sexy six' cities), given how sharply pricing has increased for core assets. Instead, investors can find many US markets with above-average demographic trends where capital has not yet flowed. But idiosyncrasies abound across US property types. Poor market selection based upon the herd mentality may produce inferior investment performance.
Michael Cohen is global strategist at Property & Portfolio Research