Investors have historically thought about development mainly as an offensive strategy, enhancing returns in up-market environments. But selective development can also serve an important defensive role as we move later into the economic cycle when core asset prices are arguably where significant risks lie.
Why development now? Because despite the lateness of the cycle, the U.S. expansion is forecast to continue. The economic expansion officially became the longest running since World War II and underlying data suggests that growth, while slowing, will remain positive and continue to generate occupancy for commercial real estate. Strong job growth is keeping consumer sentiment and spending aloft, and corporate earnings remain mostly positive. Interest rates are historically low and expected to remain so to support the ongoing expansion, and many expect the Fed may even ease them further by year end.
What’s more, the fundamentals remain supportive for development. In particular, the industrial and apartment sectors are benefiting from sector-specific tailwinds. Since the global financial crisis, the industrial sector has benefited from the increase in global trade, the retooling of supply chains, the rise of e-commerce demand, and the insatiable occupier appetite for “last-mile” delivery warehouses. Apartments have been aided by a rise in “renters by choice” given the shift to higher quality units, a reduction in the single-family home ownership rate, strong employment growth in some markets, and robust investor demand for high-quality apartments by both institutions and, increasingly, private buyers.
Higher return strategies can provide positive alpha benefits where market conditions are supportive. In addition, note the following:
- New supply in target market segments is in line with demand, supporting growth in rental rates.
- Financing remains disciplined and accretive to returns, under a sustained low-rate environment.
- In numerous instances, commercial real estate assets are selling above replacement costs.
- Investor demand has resulted in aggressive pricing for core and value-add assets, while there is less competition for development.
- Tenant demand for best-in-class assets remains robust, a positive for lease-up and exit strategies.
Newer, high-quality properties generally attract investor capital in both up- and down-markets as new projects are able to lure tenants from older or lower-quality properties in both environments. Particularly in this stage of the cycle, where existing properties are fully priced, investors might be wise to favor a strategy focused on creating these types of properties. At the same time, it’s prudent to limit the amount of time spent in the development phase and to focus on property types and locations anticipated to have the best tenant and investor demand.
Take industrial real estate as an example. Fueled by growing e-commerce sales and a reinvented supply chain, industrial properties currently represent the most coveted sector by tenants and investors. In certain real estate markets, fundamentals for industrial space are strong and demand for space continues to outpace new supply.
Multifamily is another prime example. Historically, multifamily has been considered more defensive than other property types, yet there are new opportunities in the apartment sector, particularly in the higher economic and job-growth markets, as well as markets with limited supply competition or a limited number of new properties. Today, this means steering away from locations that are attractive but have experienced an abundance of new supply on the development front.
Development projects provide an opportunity to deliver state-of-the-art new product to satisfy pent-up market demand, and reward investors.
Rod Vogel is a senior managing director at Principal Real Estate Investors. Read his full report at this link: https://bit.ly/2Mtx6Xl