Real estate industry outlook
INSIGHT ARTICLE |
Key takeaways from the winter 2020 Real Estate Industry Outlook
- Affordability, rent control and undersupply present a perfect recipe for housing issues.
- U.S. office market faces significant demographic headwinds.
- Middle market real estate fund managers are missing out on capital raises.
The U.S. real estate market will experience notable trends throughout 2020. Demographic shifts that include the aging of U.S. baby boomers and higher mobility rates among younger generations have led to undersupply in single-family homes, presenting an opportunity for homebuilders in desirable second-tier cities. Meanwhile, a lack of affordability among rental properties and rent control legislation in several major markets is hampering property growth. And the changing face of the American office—underscored by trends that include hoteling and flexible work spaces—have left developers bracing for a slowdown. While capital raises for real estate-focused funds are up sharply as investors seek safe haven opportunities, middle market fund managers are being left out.
Lack of affordability - the norm and not the exception
Rising property values, skyrocketing rents and the high cost of building additional housing will continue to threaten the ability of major U.S. metropolitan areas to attract and retain the talent needed to sustain economic growth. The overall global trend toward urbanization continues, as 55% of the world’s population now resides in urban areas; that figure expected to rise to 68% by 2050, according to a recent United Nations report. North America is the most urbanized region, with 82% of the population living in urban areas. Highpriced cities like New York, San Francisco and Seattle illustrate how inequality has become the norm in today’s housing markets. In fact, a study conducted by the National Low Income Housing Coalition shows that there is no county in the United States where a minimum wage worker participating full time in the labor market can afford a two-bedroom apartment. Fair market rent in the lion’s share of U.S. counties eats up 30% or more of a renter’s income (defined as unaffordable). Rents have continued to outpace wage growth for much of the recovery.
As investors in multifamily real estate seek diversification from core urban markets, they should take heed of another trend: population shifts. While homeownership rates nationally are historically low overall, cities, including Houston, Denver, Dallas, Seattle, Austin, Texas, and Portland, Oregon, are receiving high net migration from more costly core markets like Chicago, New York, San Diego and Los Angeles, where residential pricing is rising more rapidly than the national average. This suggests the desire for homeownership is a catalyst for those migrating. Homeownership rates peaked in 2004 at 69%. The national rate now stands at 64.8%—below the 20-year average of 66%—having recovered from a cyclical low of 63.7% in December 2016.
MIDDLE MARKET INSIGHT With interest rates at historic lows, and willingness of individuals to chase affordability, investors need to pay attention: low-cost demographic growth markets are more exposed to shifts in preferences for renting versus purchasing a home. While individuals leaving high-cost centers may possess the wherewithal to rent high-end four- and five-star apartment units, they may just as easily opt out of the renter pool.
Rent control: Short-term solution, long-term problem
With the presidential election around the corner later this year, candidates are promising alternative policy paths to deal with the issue of affordable housing. New York state, Oregon and California all passed rent control legislation in 2019, and a handful of other states has introduced similar bills. Placing a cap on rent may assist tenants in the short-term by allowing them to stay in their units; but history shows that rent control exacerbates shortages in housing supply, ultimately making it more difficult for real estate investors to invest, operate and refinance in rising-cost environments. The root cause of unaffordable apartments goes back to supply and demand—rent control serves to constrain the supply of new apartment units in the long run and will intensify issues of affordability.
Rent control is also tricky in practice: if the capped rent is too high, rent control does not support the goal of increasing affordability; if too low, it serves to contract development and further constrain supply. Additionally, rent control renders nonrent-controlled units even more unaffordable. Investors are shying away from transactions in rent-controlled areas; in New York, for example, transaction volume is being increasingly driven by marketrate assets, with the city’s recent Tenant Protection Act cooling interest in value-added plays. Rent controls, however, could actually have a positive impact on market-rate rent growth going forward since the caps serve to effectively limit market-rate product inventory growth. In order to make a dent in the affordability issue, a holistic approach that includes policies to encourage more housing supply is required.
Homebuilders: Low interest rates and healthy consumers aid expansion
Homebuilders find themselves in the midst of the second-longest economic expansion on record, and lower rates will continue to be a broad positive that fuels growth. Low unemployment, modest wage increases and an elevated savings rate near 8% all reinforce confidence that the condition of the U.S. consumer will remain solid in 2020. Homebuilders focused on lower price points will benefit more, as home prices at the high end across the country continue to impair demand.
The long-term average premium of new homes to resale homes has historically averaged around 19%, reaching a peak of 34% in 2014. The above-average premium trend is starting to reverse; new home sale premiums have dropped to 23% of resale homes, aided by the increased focus of homebuilders on the lower end of the market where demand is greatest. This emphasis will further aid affordability as the inventory of less expensive, existing homes for resale remains depressed. New home premiums will continue to moderate, but should stay above the long-term average related to energy efficiencies and smart home capabilities standard in new homes.
Stable demand environment
At 3.68%, U.S. mortgage rates are at multiyear lows, supporting continued stable demand for housing. All of 2018 and early 2019 were volatile for the housing market, as interest rates climbed as high as 4.94%, significantly affecting affordability for ratesensitive homebuyers. Given the upcoming presidential election, it’s likely the Federal Reserve will remain on hold with its interest rate policy for the duration of 2020, despite a slower pace of economic growth. The continued low rate environment will be broadly positive across all homebuyer segments, but specifically, the most rate sensitive lower end of the market.
Additionally, a diversified geographic focus outside of the richly valued housing on the coasts, that includes Florida and the U.S. Southwest, will continue to benefit homebuilders, boosted by increased demand due to net migration, will be a positive.
Currently supply isn't keeping up
On the supply side, single-family housing starts have risen more than 100% since bottoming out in 2011, but remain well below the long-term annual average to replace aging housing stock. Additionally, the construction of single-family homes has kept pace with household growth for an unprecedented eight years. Because of this, the downside risk for homebuilders in an eventual recession is limited, especially as the industry continues to underbuild relative to demographic shifts such as aging baby boomers and younger generations seeking rental properties. Supply side constraints, including the high cost of land and labor, will continue to keep growth in check and avoid any scenario even remotely close to the downturn in housing experienced during the Great Recession.
U.S. office market faces demographic headwinds
Since the end of the Great Recession in the summer of 2009, the office market in the United States has thrived on the confluence of two of the largest generations in history—the baby boomers and the millennials. In 2010, the median age millennial was 22 and just about to embark on a career, while the median age baby boomer was 56, with retirement on the horizon, but still plenty of career years to complete. In 2020, we will see millennials become the predominant economic drivers, having firmly settled into adulthood and the workforce with a median age of 32; meanwhile, boomers, at the median age of 66, are rapidly seeking retirement.
Still licking their wounds from the fallout of the Great Recession, developers have been hesitant to build, adding on 4.2% of new office space to the market since 2010. Meanwhile, the march of the millennials was unrelenting and U.S. office employment during this time experienced a 23% increase. As such, landlords saw occupancy rise to above 90% and steady rental growth, which rose by 33.5% from 2010 through 2019. This boon in rental growth brought players in flexible office space such as WeWork and Knotel to the market, looking to reinvent the office rental space.
In 2020, the tide will turn against the office landlord. Office densification, a mobile workforce and the tight labor market have presented ongoing headwinds for office landlords. While office population has been growing at 2.3% on average for the past decade, total population growth has been a more modest 0.7% during the same period. In 2020, however, the U.S. office population is expected to grow at a more moderate 0.9%, closer to the rate of total population growth. This shift, exacerbated by slowing economic growth and aging workforce, will translate into lower growth for office rents, which could potentially fall below 2% by the end of the year.
Office landlords enjoyed the show as millennials came to the office and learned to coexist with their baby boomer parents. The millennial influx led to new office technology, experiential and collaborative spaces, as well as a greater desire for remote work options. While those changes may have caused landlords to reinvent office design, no amount of open floor plans, beer taps, Zen Rooms or cafés is going to reverse the demographic trends in 2020—the good times will not keep rolling.
Middle market fund managers overlooked in new fundraising rounds
With concerns of a slowdown in both the stock market and the overall economy, institutional investors are looking to real estate as the ideal safe haven asset class for conservative investment, made even more desirable by the low interest rate environment. U.S. real estate funds in 2019 were projected to eclipse the record-setting $147 billion raised in 2018, having reached $144.6 billion through November 2019. A key concern, however, is the significant decline in the number of funds raising capital. While over 470 funds participated in 2018, this number has nearly halved in 2019.
A closer look at the new funds established in 2019 should put middle market fund managers on high alert. Private equity behemoths, Blackstone Group and Brookfield Asset Management, oversaw 25% of all new real estate funds coming to market in 2019. While these institutional investors are allocating more capital toward real estate as a conservative investment, they appear to only be comfortable contributing their money to the top-end fund managers. This creates a squeeze for the middle market, and we expect fundraising to be an obstacle for many middle market real estate fund managers in 2020, especially facing the narrative of record fundraising in the space.
Along with fundraising difficulty, middle market real estate fund managers are also having difficulty deploying the capital already in their pockets. Dry powder, identified as an area of concern in recent years, is expected to continue. Preqin data reflects dry powder at over $320 billion, up sharply from $200 billion in 2014. A long run of low interest rates has allowed capitalization rates to compress to historic lows across many real estate asset classes, particularly multifamily and industrial buildings. This is driving property prices up, and making it more difficult for middle market fund managers to find assets that can meet targeted returns. Larger fund managers, on the other hand, have the flexibility and capital to continue to acquire in the high-price environment.
MIDDLE MARKET INSIGHT As a result of market conditions, fund managers in the middle market will have to become more creative. They will need to adjust fundraising targets or look at co-investment opportunities directly with specific investors. Furthermore, acquisition strategies may need to adapt into more niche asset types or different geographic markets in order to meet desired returns.
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