Goldilocks environment expected for North American real estate in 2018

A stable 2018 is expected for both the U.S. and Canadian economies and the countries’ respective real estate markets, given balanced fundamentals and moderate expectations. The headline noise heard throughout 2017 proved to be just that, as capital markets continue to be resilient. Long-term secular trends continue to evolve and drive strong financial performance. The construction of portfolios that balance “goldilocks” and “bear” scenarios are recommended in LaSalle Investment Management’s Investment Strategy Annual (ISA) 2018.

The report suggests that in 2018 the economy will continue to expand at a steady pace, with no single risk, despite headlines, serving as a catalyst that will reverse the current momentum. Job growth is a critical driver of real estate demand and the U.S. continues to create new jobs at a sufficient pace generating good real estate demand. Natural demographic shifts in the labor force, including baby boomers nearing retirement, millennials reaching working age and slowing immigration flows to the U.S. have all contributed to low unemployment. Canada’s real estate markets should continue to perform well, with the renegotiation of the North American Free Trade Agreement (NAFTA) still causing some uncertainty. However, modest enhancements to the agreement could be beneficial to Canada.

“With buoyant capital markets, strengthening economies and the steadily rising demand for real estate in investment portfolios, ‘Goldilocks’ conditions are what real estate investors can expect in 2018,” said Jacques Gordon, global head of research and strategy at LaSalle. “North American property market fundamentals continue to experience strong, positive momentum, thanks to demand-side growth that is keeping pace with an active supply pipeline. However, uncertainties still exist surrounding tax reform, healthcare reform, trade treaties and foreign policy. The ISA’s best investment recommendations focus on how long-term secular trends are evolving and how they can drive financial performance across multiple economic and real estate cycles.”

Additional ISA 2018 findings for the U.S. include:

• Job growth is a critical driver of real estate demand and the U.S. continues to create new jobs at a sufficient pace generating good real estate demand. One labor market segment that is already very tight and seeing costs rise is construction, which is creating high single-digit or low double-digit increases in the hard and soft cost elements of real estate development budgets.
• Flexible workspaces and e-commerce are influencing demand and asset performance, and data analytics can be utilized to identify sectors, sub-markets and specific assets with the highest potential. Pressure from e-commerce are forcing brick and mortar retailers to adapt to a new era.
• Debt is expected to be plentiful in 2018, yet lenders will remain conservative in underwriting. The major lending sectors are operating normally without the hurdles of 2017, including the maturity of 2007 vintage loans, CMBS risk retention and Fed oversight of bank real estate. In 2018, there are fewer risks and normal market conditions should persist.
• Jerome “Jay” Powell, the next chairman of the Federal Reserve, is expected to continue his predecessor’s careful path toward gradually tightening monetary policy. There is a risk that long-term interest rates increase faster than the market or Fed expect, which could lead to stock market declines and incentivize investors to rebalance their portfolios away from real estate.  More likely, the rapid rise in stock prices in 2017 will lead to additional real estate allocations in 2018.

U.S. Property sector insights include:

• Warehouses/Industrial/Logistics: The industrial hub markets, including Riverside, Chicago, Atlanta and Dallas, are experiencing high levels of construction combined with very strong demand. This positions those markets to perform well in 2018, although risks would escalate should economic growth slow. E-commerce continues to reshape the industrial market and boost warehouse demand, particularly in the major population centers.
• Apartments: Low yields and slowing income growth are proving to be short-term challenges for the apartment sector. Urban apartment markets are continuing to see high levels of supply, especially among high-quality/high-rent segments of the market, although construction should slow in 2018. Suburban markets, where market fundamentals are more balanced, should see steady inflationary rent growth.
• Retail: E-commerce will continue to reshape this sector and impact real estate investment performance. Retailers will be forced to invest in innovation and advanced data analytics. Grocery-anchored retail space in well-located centers remains in demand and this is reflected in the strong capital market activity at these centers that we believe will continue.
• Office: Gateway CBD office markets such as New York, Washington, D.C., and San Francisco are experiencing above-average levels of supply and constrained demand which will continue to constrain office benchmark returns. Success in this sector will be asset-specific with a continued growing importance of amenities.

“Nationally, supply and demand are in balance in the U.S., with higher levels of supply and demand in industrial, apartments, and some office markets,” said Rich Kleinman, managing director of research and strategy in the U.S. for LaSalle. “Meanwhile, the retail and most suburban office markets are in balance, with very low supply matching limited incremental demand (and in some cases, negative supply growth). The investment opportunities tend to be specific strategies within property types. Our favorable view of a particular strategy is generally based either on its having a stronger income profile, less risk, or on our taking a different view of fair pricing than the broader market.”

Elsewhere in North America, the Canadian economy, which generated an above-trend GDP of 3 percent in 2017, has now mostly adjusted to lower oil prices, and the ISA anticipates Canada’s economy will see moderate growth of 2.0 percent to 2.5 percent in 2018 and 2019, which will likely lead the G7. Trading volumes are also likely to remain strong for Canada in 2018. Large domestic pension plans that are overweight Canadian real estate will continue to place high-quality assets on the market as they seek to diversify internationally, thus creating attractive core and core-plus investment opportunities. This is not a negative view of Canada from these pension funds, rather they are simply seeking diversification. Attractive value-add opportunities are expected in 2018 as several REITs intend to shed non-essential assets in both primary and secondary markets to  focus on urban development opportunities.

“While the Canadian real estate market has a reputation for being tightly held and difficult to enter, this is not necessarily true as the country has experienced several foreign capital sources successfully establishing portfolios in Canada by targeting specific property types and partnering with traditional market participants,” said Bill Maher, Head of Research and Strategy for North America at LaSalle. “The Canadian dollar rose in 2017, however it is expected to remain below parity with the U.S. dollar over the medium term. This keeps Canadian assets attractive to foreign capital and will help maintain core asset pricing.”

Globally, the ISA finds that high asset prices, rising levels of liquidity and the “hunt for yield” all raise new challenges for investors in 2018. Real estate will not be a panacea for all these issues, nor can it shield investors entirely from future turbulence in the asset markets. However, real estate will almost certainly respond differently to all the cyclical, structural, and secular changes that are possible in the next three years, relative to stocks, bonds, and other alternative investments.

To read the full report, click here.