Domestic and foreign institutional investors have been piling in to prime property in gateway cities. But, as Nangyal Tsering reports, question marks hang over secondary markets as the economic future remains unclear

The US commercial property market is showing signs of recovery, but the general outlook remains cloudy and the trend is towards flight to quality, according to analysts. It is widely expected that the recent turmoil in the financial markets following Standard & Poor's sovereign credit rating will further accentuate the migration towards quality assets.

Much will depend on the job market, although offshore investors eyeing superior returns have already been buying trophy properties in big cities. These assets are located in the ‘gateway' markets, such as New York, Boston, Washington DC, and Los Angeles.
"For the past 12 months, these markets have taken the lion's share of the cross-border investments," says Kevin Smith, managing director at Prudential Real Estate Investors, which operates as Pramerica Real Estate Investors in Europe.

The recent crash in the stockmarkets and the fears of a double-digit recession might derail hopes of a stronger recovery in the real estate market in the second half. The biggest concern going through the second half of 2011 is weak tenant demand and the difficulty in leasing vacant space, and "that businesses might delay hiring, based on lower confidence", Smith says.

While US real estate has emerged from its market trough, the economy has yet to see the kind of job growth that normally follows a recession. Smith adds: "And now we are hearing about more layoffs - potential layoffs, anecdotal evidence of weak job growth." He warns that although investors are looking to make new investments based on an improving outlook, if the economy fails to deliver the expected growth, it will lead to disappointment.

"Many investors want to increase their real estate holdings today. Expectation is that the economy is going to grow consistently, with a substantial recovery in job growth," Smith says. However, he expects the US GDP and job growth to speed up in the second half of 2011. "We were at the bottom in 2009, early 2010, and values have increased pretty steadily since then. We are definitely way past the trough pricing," he says.

While investors have become bullish and transaction volumes are up, the market remains bifurcated. Asieh Mansour, head of Americas research at CB Richard Ellis, says: "Investors are more interested in multi-housing assets, trophy office buildings in the top market." She says that, as a consequence, strong demand for these assets have pushed prices higher in the top-end market. "Institutional capital is primarily targeting lower-risk core property assets," says Mansour. "It is typically in the trophy buildings in primary markets where investment dollars are huge."

Mansour also believes that if the economy fails to recover, investors will become more risk-averse, which might delay the wider recovery in the property market. She says: "Fundamentals are still struggling. We have pretty high vacancy rates. If we do not see a meaningful recovery in jobs, it would create further downward pressure on rents, and on underlying operating income that landlords receive from buildings."

But while investment dollars are going into the top gateway markets, secondary and tertiary markets are also showing capital inflows. According to Real Capital Analytics (RCA), secondary markets such as St Louis, Baltimore, Tampa and Portland, and tertiary markets such as Houston, San Jose and Orange County, have been showing good growth.

Tertiary markets in particular registered 129% year-on-year growth which, according to RCA, is "a sign that investors are embracing smaller cities".

In terms of the primary markets, strong sales in hotels combined with already robust activity in the office sector, pushed Washington DC to fourth place in the first half. San Diego and Atlanta, also moved into the top 10, at number six and seven, respectively, leaving out Houston and Seattle.

The markets that had relatively underperformed so far - such as Atlanta, Phoenix, Las Vegas and Philadelphia - also came roaring back, by showing strongest annual growth in the first half, according to RCA.

But given the uncertain economic situation and the possibility of a jobless recovery, it is unlikely that demand for non-core assets will increase in the near term. "Investors are taking a wait-and-see attitude when it comes to more risky strategies, such as value-add assets or opportunistic," Mansour says.

While the widespread fear of a second recession fuelled concerns that the outlook for the US market was not as strong as expected, there is still uncertainty about what the future holds for the American economy. One thing is sure, though: since it is a lagging indicator, tenant demand will not show up until the job market grows.

Job market improving
Recent numbers indicate that the job market is improving slightly. Despite layoffs of nearly 34,000 by the US government, the US Bureau of Labor Statistic reported that the job growth in July was stronger than expected thanks particularly to strong private sector hiring. In addition, initial jobless claims fell by 7,000 in the week ending 6 August 2011 to 395,000, the lowest figure since April, showing that job market might finally be growing, albeit at a slow pace.

Offshore investors from Hong Kong, Spain, Argentina, Canada and Malaysia are buying properties. While the Americans are worried about the debt crisis and the potential recovery of the economy, global investors continue to consider the US the favoured destination.

Despite the weak performance and uncertainty, the US remains a top market. In the first week of August, Korea's National Pension Service Fund (NPSF) committed up to $650m for real estate funds investing in North and South America.

Some of the biggest investors active in the US market have been Canadian pension funds.

The Canada Pension Plan Investment Board (CPPIB) entered into a joint venture with Allianz Real Estate and Archstone to invest in several US real estate assets.

The British Telecom Pension Scheme, meanwhile, has committed more than €100m to Hermes Real Estate's new US real estate fund, making it the cornerstone investor in the closed-ended HUH US Real Estate Income fund that will target mispriced assets in various sub-sectors.

Global investors are "interested in the US because, despite volatility, the US is still a large, transparent and liquid market", Mansour says. "You are going to see continued flow of capital to US shores."