1. Intensifying Transformation
The diversity of investor goals and choices is healthy—far healthier than the herd behavior that has sometimes characterized markets. As an international investment fund executive told us, “The differentiation of opportunities has—to a degree— expanded; niche product types like senior housing and selfstorage are being viewed as ways to ‘round out’ real estate holdings, taking advantage of specialized uses that are not ‘averaged out’ in major trends.” Many interviewees pointed to the
2. Easing into the Future
Mining the potential for productivity improvement is the missing link to sustained or enhanced economic growth in a labor-short era. The temporary bump provided by the tax stimulus in 2018 notwithstanding, growth since the global financial crisis has been moderate at best. The key reason appears to be disappointingly low productivity growth. Last year in Emerging Trends, we addressed this issue as “Working Harder, Smarter.” Despite the obvious need stemming from the “double whammy,” U.S. research and development (R&D) spending has dropped to 0.7 percent of gross domestic product (GDP), down from over 1.2 percent in 1976, according to the American Association for the Advancement of Science.
3. 18-Hour Cities 3.0: Suburbs and Stability
Economic growth also appears to be on the side of 18-hour cities. While the prior trend laid out a future where the economy could experience slower average growth in the future, those 17 markets at the top of this year’s survey appear to be clearly ahead of the national average when it comes to growth. The projected average annual population growth over the next five years in the 17 markets is 1.3 percent compared with 0.7 percent for the United States as a whole, while projected five-year annual employment growth is 1.2 percent compared with 0.6 percent for the United States.
4. Amenities Gone Wild
For decades, the term amenity creep has been current in the hospitality industry. In the Travel Industry Dictionary (yes, there is such a thing), it is defined as “the tendency of hotels to add new perks and features in an effort to attract more clients and respond to competition.” In an era when concierge service is being offered in apartment buildings, offices, and even retail establishments, real estate in general needs to think about this topic. We might need to think about the direction and staying power of real estate competition based upon amenities beyond those typically provided in the past.
5. Pivoting toward a New Horizon
A number of factors are combining to create this transitional pivot point. The first is the size of the U.S. real estate market, which is an enticingly large target: As of the end of 2017, the U.S. Bureau of Economic Analysis says that the real estate industry represents 13 percent of U.S. GDP. The second is that the target market is diverse, with most real estate companies operating within only a few segments of the overall industry. With this level of fragmentation, there is certainly no clear leader in the real estate technology business. This appears to play right into technology’s knack for fomenting consolidation. Third, opportunities for success appear to be unlimited. Real estate technology has the opportunity to touch virtually every aspect from fintech to proptech, from supply chain logistics to end user convenience, from manufactured building components to workplace productivity, from data analytics to tailored amenities, and more.
6. Get Smart: PI + AI
While it is difficult to predict exact job changes, the examples already discussed show that the potential for AI to influence how we work is significant. Forrester Research estimates that by 2027, AI could affect up to 25 percent of the daily tasks performed by every job category, ultimately enhancing the personalized intelligence (PI) of future workers. For example, although secretarial and administrative jobs, which have been steadily disappearing for years due to automation, are projected by the U.S. Bureau of Labor Statistics (BLS) to see a further 5 percent decline (192,000 jobs) by 2026, office-using occupations such as information clerks and customer service representatives, who will be users of AI in their daily tasks, are expected to increase of about 5.5 percent (270,000 jobs). Likewise, the BLS anticipates a 12 percent gain in computer and information services managers (44,200 jobs) and a 10 percent rise in the number of property and real estate managers (32,000) jobs by 2026, jobs that will be using proptech tools, including AI.
7. The Myth of “Free Delivery”
Although e-commerce growth has put B2C shipping in the limelight, B2B parcel delivery still accounts for twice the volume of goods traffic in the United States. Fleets of panel trucks arrive at business locations at the very times when streets and sidewalks are most crowded, adding to the costs of shippers and transportation companies. The total costs are enormous, affecting not only businesses directly but also all taxpayers as public budgets pay to fix problems. Some numbers: over five years, congestion costs to business are estimated at $240 billion; spending on maintaining America’s roadways is $68 billion annually, just 37 percent of what is needed to prevent further deterioration.
8. Retail Transforming to a New Equilibrium
In an important way, the shift from simply merchandizing goods to providing space for services and “experiences” is no fad: it reflects the distribution of consumption spending across the economy. Excluding items such as vehicles and gasoline, consumption spending on durable and nondurable goods totaled $2.8 trillion at midyear 2018. Services spending amounted to $4.6 trillion, once “nonstore” services like transportation, housing, utilities, and recreation are set aside. Clearly, the trend in retail leasing to accommodate urgent-care medical facilities, health and fitness providers, restaurants, financial services, and entertainment venues matches the way consumers are spending their dollars in ways that traditional malls and power centers did not.
9. Unlock Capacity
Nationally, though, rising levels of unaffordability are largely a function of underproduction at all price levels except for luxury housing, both ownership and rental. National Association of Realtors (NAR) data on affordability show that, since 2015, the combination of rising single-family home prices and upward pressure on mortgage rates has triggered a 15 percent decline in its affordability index. The National Association of Home Builders estimates 2018 single-family housing starts at 900,000, which is 400,000 units shy of sustained demand.
10. We’re All in This Together
Sensitivity to ESG issues has increased for U.S. real estate with the public decision of the current U.S. administration, in 2017, to withdraw from the Paris Agreement, although this decision cannot be formally implemented until 2020. Real estate has been proactive on sustainability issues for many years and, as a matter of self-interest as well as social responsibility, is moving ahead to advance its sustainability performance regardless of the direction of national policy.
Expected Best Bets for 2019
The expansion of e-commerce is far from over, and the need for facilities to accommodate a denser distribution network is acute and will only increase over time. Warehouse/distribution vacancy is at a historic low, as one senior adviser noted in his interview. While ports and hub cities still play key roles, infill opportunities give “last mile” break-bulk sites—even multistory properties—a chance to join the party. Barring a trade war of serious proportions, industrials offer great risk-adjusted returns.
While the multifamily sector registered an overall NCREIF total return of 6.38 percent, the garden apartment component was near a double-digit total return at 9.33 percent. Appreciation in value accounted for the overperformance in the garden apartment group. Pricing for garden complexes reflects a higher-yield 5.7 percent cap rate, compared with 4.9 percent for mid-to-high-rise properties. The strong move toward secondary and tertiary markets, and the return of interest to suburban assets—especially by private equity—bode well for these multifamily assets.
Quick-flip value-add deals.
It’s all about timing, and interviewees from both the institutional and entrepreneurial realms see late-cycle opportunity. The window of opportunity is narrow— the ability to execute by 2020 is key. And the geographic focus needs to be in markets where assets have not yet been priced to perfection. These are mainly second-tier markets in the South and Intermountain states. Affordability to middle-market tenants—both commercial and residential—describes where underserved demand can be satisfied. This is not low-hanging fruit by any definition; but for yield-oriented investors with turnaround expertise, such deals are right in their wheelhouse.
Redeployment of obsolescent retail assets.
Many shopping center properties are just not going to come back as successful retail assets. But while few have been reduced in price to mere land value, many are well below replacement cost and have good locations for alternative uses. If a site is sufficiently large, mixed use is a great option for close-in suburbs looking to exploit maturing millennials’ desire to enter their next life-cycle phase. There also is an opportunity to turn the tables on the e-commerce trend that fostered the obsolescence by redevelopment into distribution facilities.
Issues to Watch in 2019
Last year, we presented data showing the increasing incidence of natural catastrophes, most due to climate change, since 1980. The evidence of floods, wildfires, and violent storms in 2018 indicates that the risk has been intensifying. That means that property/casualty insurers and reinsurers are experiencing massive payouts, and they will be pricing this into premiums going forward. Having adequate coverage and budgeting for increased operating expenses should definitely be high on the list of items that property owners need to watch in 2019.
Cybersecurity risk management.
Over the past several years, the vulnerabilities that come with interconnectedness have become more and more obvious. This has affected governments, retailers, and utility systems, and extends deeply into the property sector as the “internet of things” turns common building components and systems into gateways to cyberspace. REIT interviewee highlighted a need to establish industry norms and best practices for both primary defensive purposes and for evaluating risk/reward parameters stemming from technology.
As a public policy priority, the anticipated focus on America’s infrastructure needs has evidently been placed on the back burner. That does not mean that infrastructure is less of an issue, and its deficiencies are impactful for real estate. The American Society of Civil Engineers provides details not only on the multitrillion-dollar shortfall in investment in key assets, but also the costs that affect business. By 2025, the United States sacrifices $3.9 trillion in GDP and $7 trillion in reduced business sales. Failure to address the issue means 2.5 million fewer jobs created and a shortfall of household income of $3,400 annually. Congestion and delays along the supply chain add to greater costs of doing business, and there also is the added event risk that comes along with potential catastrophic failure in roads, bridges, dams, and transit systems.
The draconian approach to border security is a massive self-inflicted wound with immediate negative economic consequences and long-term weakening of our national growth potential. Emerging Trends has addressed the consequences for the labor markets in previous years. Now, the impacts on demand growth going forward, the reduction in the baseline for real potential GDP growth to less than 2 percent annually beginning in 2023 (according to the Congressional Budget Office’s forecast), and the implications for bringing the nation’s fertility rate below population replacement level should all give us pause. And, as a knock-on effect, these consequences reduce the U.S. comparative advantage as a place for inbound investment in real estate and could see other world cities become capital magnets, eclipsing key American markets
One key risk toward the end of economic cycles is the supposition that expansion will persist well into the future. It seems self-contradictory, but many take comfort in the adage that turning points are impossible to predict and that no trigger for a downturn is now apparent on the horizon. At present, however, it seems that rather than a single trigger, there is an accumulating number of risks that interact with each other (labor shortages, a flattening yield curve, a potential asset bubble on Wall Street, tariff and trade tensions, ongoing geopolitical risk) and argue for greater defensiveness. The decline in real estate transaction volume seems to say that investors as a group are pulling back in the face of such concerns. But even while that is happening, cap rates not only have trended low but also are convergent (with just a 30-basis-point differential between offices, retail, and industrials at midyear 2018). At current cap rates, risk premiums are so thin that is likely that many deals are pricing risk too cheaply. That mispricing becomes apparent once recession strikes—and that is not a question of if, but rather when.
Record-Breaking Costs from Natural Disasters Help Catalyze a Focus on Building Resilience
Natural disasters in 2017 cost an estimated $306 billion in the United States, shattering previous records because of hurricanes Harvey, Maria, and Irma. The high cost of U.S. events is reflected in the fact that insurers covered a record $135 billion globally in 2017, and the United States made up roughly 50 percent of the total payout in comparison to a typical 30 percent.
While it is impossible to ever be fully prepared for an extreme storm like Harvey, real estate developers, investors, and local governments are increasingly looking for strategies to reduce the likelihood of damage from major events. Concerns about potential increasing insurance costs, and reduced federal resources for disaster recovery, also are growing. As a result, interest in the concept of resilience—the ability to prepare and plan for, absorb, recover from, and more successfully adapt to adverse events—has broadened in both the private and public sectors. This growing focus on resilience is being driven by several factors:
Climate change is contributing to an increased frequency and intensity of storms, with trends indicating that 2017 is unlikely to be the most expensive year for long. Beyond storms, other climate change impacts also present risks: nearly 25 percent of the NCREIF’s Property Index value is in those cities among the 10 percent most exposed to sea-level rise. Extreme heat also is likely to affect the real estate industry. For example, Europe’s 2018 heat wave led to notable infrastructural impacts, such as the temporary shutdown of nuclear plants.
Potential for decreased property values:
While many high-risk areas still have relatively strong market values, regional studies have identified areas where property values have decreased due to flood risk. While many of these studies have focused on single-family residential, the lessons are still applicable. A 2018 Harvard study of Miami–Dade County determined that properties at lower elevations are gaining value at a slower rate than those at higher elevations. In 2018, the First Street Foundation reviewed 9.2 million real estate transactions, comparing coastal and flood-vulnerable properties to those at higher elevations, and determined that flood-vulnerable properties in New York, Connecticut, New Jersey, Florida, South Carolina, North Carolina, Virginia, and Georgia had lost $14.1 billion in value between 2005 and 2017. This includes $6.7 billion from the tri-state area alone.
Opportunities for market differentiation:
As investors, tenants, and homebuyers express increasing concern about exposure to extreme weather, some real estate developers have embraced resilient design as a market differentiator. Approaches can include the elevation of buildings or mechanical elements, incorporation of backup or passive power sources, building hardening and enhanced wind preparedness in hurricane-prone areas, and the incorporation of green infrastructure and landscape design to absorb water during routine and peak events.
Investments and incentives from the public sector:
Many cities are seeking to enhance resilience through requirements, incentives, and incorporation into zoning and building codes. For example, in spring 2018, Houston’s city council made the first changes to flood regulations in ten years, requiring new construction and retrofits to be two feet above the 500-year floodplain. Some cities are also seeking to set an example via investments in resilience for capital projects or public infrastructure. Miami Beach is currently investing $600 million to elevate roads and pumps to combat sunnyday flooding, and in 2018, New York City reissued Climate Resiliency Design Guidelines to inform the design of all city capital projects.
Resilience is a burgeoning field, but research on the impact of resilience investments is nascent. Still, some investors in resilience are projecting longterm gains in value and near-term reductions in operating expenses. For example, investments in resilience may make properties more attractive to Class A commercial tenants due to the better likelihood of business continuity. Shorter-term operational savings may include reductions on insurance premiums. Investing in resilience may also become an effective part of a community engagement strategy and help limit local opposition to a project. Numerous new tools are in development to both enhance building-scale resilience, and track and measure resilience. For example, GRESB’s Resilience Module, the U.S. Green Building Council’s RELi standard, and the nationally applicable Waterfront Edge Design Guidelines all launched in 2017 and 2018