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Posted by Heidi Schwartz
The U.S. real estate recovery is set to continue into 2014, with investors increasingly looking beyond some of the traditionally popular markets to secondary markets in search of higher yields, according to Emerging Trends in Real Estate® 2014, co-published by PwC US and the Urban Land Institute (ULI).
According to real estate market participants, the predicted growth in secondary markets is driven by investors searching for returns as opportunities in core markets become harder to find and the best assets become more expensive. As a result, the report anticipates that 2014 may be the year that many investors who have traditionally focused mainly on large established markets such as Boston, Chicago, Los Angeles, New York City, San Francisco and Washington, will be expanding their focus to other cities in order to protect capital. This trend, first noted in last year’s Emerging Trends report, is likely to build substantial momentum next year, given the steady pace of improvement in market fundamentals in secondary markets, and with more investments in those markets meeting investors’ risk/return metrics.
The movement into secondary markets is underpinned by the anticipated increase in both debt and equity capital during 2014. Respondents were particularly positive about the prospects for equity capital from foreign investors, institutional investors and private equity funds, as well as debt from insurance companies, mezzanine lenders, and issuers of commercial mortgage-backed securities.
“Real optimism has emerged as a key theme in the real estate market for 2014 as trends are progressing significantly through the economic and real estate recovery cycles,” said Mitch Roschelle, partner, U.S. real estate advisory practice leader, PwC. “The steady economic recovery and job creation has created ‘tailwinds’ that have propelled the commercial real estate market forward, and momentum of this recovery seems powerful enough to weather spikes in interest rates that may be inevitable.”
“The anticipated interest in secondary markets is indicative of how the U.S. real estate recovery is expanding beyond the traditional investment hubs,” said ULI Chief Executive Officer Patrick L. Phillips. “Access to greater amounts of both debt and equity financing, combined with a sustained improvement in the underlying economic fundamentals, means that the opportunities and returns offered in smaller markets are potentially very appealing.”
Emerging Trends notes that the key threat to market recovery is the timing and pace of any interest rate increases. The report forecasts a modest increase in the short term, but does not expect a small increase to cause a major disruption to the recovery. If higher interest rates are a function of the Federal Reserve Board’s response to an improving economy in 2014, the increased borrowing cost will be offset by greater demand and therefore higher rents. However, the report cautions that faster-than-anticipated rises or rates growing faster than the underlying economy could undermine the recovery.
In 2013, investors were flocking to commercial real estate searching to add yield to their portfolios that comprised of more traditional assets of stocks and bonds. In 2014, investors will re-focus on the fundamentals that are being driven to commercial real estate as the prospects of cash flow growth are increasingly evident, according to survey respondents. There will also be demographic shifts with the emergence of Generation Y’s preference for city living, compact development and expectancy to move more in the next five years than the overall adult population.
A number of the markets anticipated to perform well in this year’s report are benefiting from the continued influx of foreign capital. Miami, which rose to number eight in the 2014 forecast from 12th and 17th place in 2013 and 2012, respectively, is benefiting from South American investment. Seattle, which ranked sixth in this year’s survey, is another example of a top city with its global connections, high rate of educational attainment, and growth in the technology industry, making it a hub for international investment.
Markets to Watch
A snapshot of the top five markets ranked by survey respondents and their outlook for each market:
1. San Francisco – San Francisco is the top-ranked market for the second year in a row, driven by a thriving economy which is projected to add jobs at a rate of two percent next year. According to survey respondents, San Francisco is a solid “buy” for all property types.
2. Houston – Houston improves from its number-five position in last year’s survey, due to its investment and homebuilding prospects. Housing, non-residential construction, and a revival in exploration industries could be the key economic drivers.
3. San Jose – San Jose is the third-ranked market for the second year in a row, with investors attracted to the prospects offered by the city’s technology industry. Respondents believe that the job and income growth generated by the sector will support rising real estate demand.
4. New York – New York slips two places to number four in this year’s survey. The city’s investment and development components are still rated as “good,” however there is a growing concern that pricing is once again becoming too high. Rental apartments and hotels are the property sectors that respondents feel offer the best opportunities in 2014.
5. Dallas/Fort Worth – Dallas/Fort Worth moved up four spots to number five in the 2014 survey. Survey respondents rated Dallas/Fort Worth highly for investment and development, but it was its strong homebuilding prospects that moved the market up in this year’s survey. Industrial/distribution is the property type that survey respondents most recommend as a “buy” in this year’s survey.
The most significant example of the shift by investors from some core markets and into alternate markets is seen in the findings for Washington DC, a long-time favorite for investment and development due to the economic stability provided by its close association with the federal government. Highly ranked by Emerging Trends prior to and during the recession, and ranked number one as recently as 2011, Washington, DC slipped from eighth place in the 2013 report to 21st in the 2014 investment rankings, positioning it close to the middle of the 50 markets ranked in the report. The report notes that “fed (federal government) fatigue” appears to be diminishing the investment appeal of the nation’s capital, in that what was once viewed as an asset is now being seen as a liability, with concerns caused by the federal shutdown and the ongoing uncertainty surrounding federal budget cuts and government spending.
In terms of market sector prospects, industrial tops the ranking in this year’s report, with warehousing standing out as a particularly strong subsector. Warehousing was a clear favorite among survey respondents, with 64 percent making a “buy” recommendation for the subsector and less than 10 percent advising selling. With retailers and manufacturers continuing to shorten their supply chains, the ongoing growth in e-commerce, especially in same or next-day delivery, is fueling the requirement for vast fulfillment centers close to major cities. Research and development industrial, self-storage and data centers are also expected to show further improvement.
As a sign of improving investor optimism, the report signals that in 2014 there may be an increase in new development activity in subsectors such as central business district office and limited service hotels that have not seen new construction in several years.