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Annual strategy outlook for 2018
Inside Real Estate
Inside Real Estate • November 2017 | 1
Executive summary
Key themes for 2018
Economics trumps politics temporarily – Political stress and uncertainty
have been a hallmark of the world in the past 12 months and are likely to remain
top of mind in 2018. Remarkably, despite this environment of political turmoil, the
Contents:
global economy has entered a period of synchronized growth. Economics is rarely
disconnected from politics for long; but we are quite constructive on the economic
outlook over the next 12 months, given the positive catalysts in place across the 3
Chapter 1: May you live
global economy. Given the historically positive correlation between economic in interesting times:
growth and commercial real estate, our base case for 2018 reflects a continuation Five themes to guide us
of the current cycle, albeit with a more tempered outlook for occupier demand and through 2018
investment performance.
Synchronicity in global growth – The global economy is accelerating in unison for 8 Chapter 2: Implications
the first time since 2010 and most leading indicators point to a year of above-average for real estate strategy
growth in 2018. The United States is expected to benefit from this synchronized
global expansion, with domestic growth expected to accelerate modestly into the
9
Chapter 3: Space market
first half of 2018. While the United States edges towards its longest expansion since
fundamentals
World War II, an equally positive development has been a more favorable outlook for
both the Eurozone and China. As two of the largest trading partners with the U.S., a
return to growth in these areas would be a positive development for both the dollar 23 Chapter 4: Four quadrant
and U.S. exports - further supportive of domestic GDP growth. strategy recommendations
Expect higher short-term interest rates in 2018 – The Federal Reserve will
have a new chair and the fed funds rate will be higher at the end of 2018, although
our expectation is for a tempered increase in short-term interest rates accompanied
by some balance-sheet reduction. The nomination of Jerome Powell to be the new
chairman of the Federal Reserve adds an element of uncertainty to monetary policy
guidance. For real estate investors, a less accommodative monetary environment,
accompanied by modest reduction of liquidity, is likely to result in a slightly higher
cost of capital – especially those with short-term financing requirements. However,
we are not convinced that long-term rates shift higher materially (i.e., the yield curve
steepens) given that longer-term inflation and growth expectations remain quite
weak. If the long end of the yield curve does shift higher it would arguably be in
response to stronger growth and inflation – both generally positive outcomes.
Remain constructive but brace for uncertainty – Geopolitical risks stemming
from the U.S. administration’s “America First” policy, along with tensions with Iran
and North Korea, have highly unpredictable consequences. In addition, a potential
disconnect with the Fed may tip capital markets into disarray. Further, a failure by the
Trump administration to implement meaningful policy, dovetailed with the unknown
outcome of the investigations into Russian interference in the U.S. presidential
elections, has potentially very destabilizing consequences. However, the timing on
any one of these risks boiling over is quite uncertain, which makes 2018 even more
challenging from a risk-management perspective. Although ill-conceived political
actions often resurface to derail growth, we are relatively confident that economics
will drive markets over the next 12 months.
Increasing convergence in investment performance expectations – We
expect investment performance to converge across quadrants, but commercial real
estate is expected to remain important in multi-asset portfolios. From a tactical
perspective, we remain cautious regarding core real estate equity, but recognize it
may be appealing to long-term investors. We will continue to look for relative-value Coda
opportunities in subordinate debt in non-gateway markets, new-issue CMBS, and Denver, Colorado
select value-add private equity real estate.
Inside Real Estate • November 2017 | 2Chapter 1: May you live in interesting times: Five Themes to Guide us through 2018
Chapter 1
May you live in
interesting times:
Five themes to guide
us through 2018
Investors looking to 2018 may find the old Chinese curse that goes
something like, “may you live in interesting times” quite appropriate.
Despite elevated global According to this proverb, interesting times are generally periods of time
associated with some form of strife and discord and uninteresting times
uncertainty and stress,
more akin to a harmonious life experience. As much as investors hope to
the world economy has look to calm waters, it is likely that the next 12 months will fall under the
continued to improve “interesting” category of experience.
and has entered a
The past 18 months have seen nativism and protectionism rise in the major
welcome period of developed economies of the United States, the United Kingdom, Austria,
synchronized growth. Germany, and France. Catalonia’s referendum has imposed upon Spain’s
sovereignty. North Korea’s missile launches have raised tensions with the
United States. And increasing consolidation of authority by Xi Jinping in
China suggests a more aggressive foreign policy. The global picture is one of
deep political and social angst.
However, in a remarkable disconnect between politics and economics,
despite elevated global uncertainty and stress, the world economy has
continued to improve and has entered a welcome period of synchronized
growth. Ill-conceived political actions often resurface to derail growth but we
are relatively confident that economics will trump politics over the next 12
months. So even if policies and politics may remain “interesting”, we believe
economies will continue to perform quite well.
To a large extent, developed-market central banks led by the Federal Reserve
(Fed) deserve credit for steadying influence in global monetary policy.
Global central banks have engineered a remarkable period of low interest
rates by keeping policy rates low and purchasing bonds across different
durations to maintain low borrowing costs. This monetary accommodation
has led to significant asset reflation, although it has not been nearly as
effective in raising economic growth. That is not surprising, however, given
that economic theory dictates limited effectiveness of monetary policy
in sustained low-rate environments, since it tends to negatively affect the
transmission mechanism for credit.
U.S. commercial real estate markets have been a major beneficiary of low
interest rates, delivering several years of outsized investment performance.
In our annual 2017 Inside Real Estate, Principal Real Estate Investors laid
out a base case scenario of lower-than-consensus interest rates, but one
3 | Inside Real Estate • November 2017Chapter 1: Continued
where core real estate returns would slow. The lower returns would result from moderating
appreciation. Consequently, our relative-value calls focused on an overweight to the industrial
sector, which had a strong net operating income (NOI) growth outlook, along with high-yield
debt and new-issue CMBS, which had attractive pricing metrics. We also took the view that, in an
uncertain world, global investors would continue to view the United States as an attractive and
relatively low-risk market.
As we look ahead to 2018 and beyond, here is one question from investors that we hear more
than any other: “Where do we go from here?” Seven years into the real estate recovery and
eight years into the economic expansion, there is a growing sense that both the economic and
real estate cycles are past their primes. While that may be true, the expansion’s demise is not
necessarily imminent; unlike humans, economic expansions “do not become progressively more
fragile with age” as the San Francisco Federal Reserve pointed out in a 2016 analysis.
Given the historically positive correlations among economic growth and commercial real estate
demand and performance, our base case for 2018 reflects a continuation of the current cycle,
albeit with a more tempered outlook for occupier demand and investment performance. The
catalysts that typically precede slowdowns or recessions – financial imbalances, excessive central
bank tightening, or downward pressure on corporate margins – are all thankfully minimal.
Ultimately, imbalances will eventually arise, but none appear evident over the short-term and
investors should be able to find opportunities within commercial real estate over the coming year
– particularly when compared with other risk assets.
In recognition of the complex path that lies ahead in a global environment of heightened political
stress and potentially discordant monetary policies, we have identified five broad themes within
our base case that will help investors navigate through 2018 and perhaps beyond.
Exhibit 1: Economic growth now in sync...
Global GDP Growth
World World LTA = 3.5% per annum
Advanced Advanced LTA = 2.4% per annum
Emerging and developing Emerging and developing LTA = 4.5% per annum
10%
Global GDP growth, annual change
8%
6%
4%
2%
0%
-2%
-4%
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022
(f) (f) (f)
(f) forecasted
Source: IMF World Outlook Database, October 2017
Inside Real Estate • November 2017 | 4Chapter 1: Continued
U.S. economic expansion should continue to run
The economies around the world are accelerating in unison for the first time since 2010,
and most leading indicators point to a year of above-average growth in 2018. The United
States is expected to benefit from this synchronized global expansion, with domestic growth
expected to accelerate modestly into the first half of 2018 (Exhibit 1 on previous page). While
the United States edges towards its longest expansion since World War II, an equally positive
development has been a more favorable outlook for the Eurozone and China. As two of the
largest trading partners of the United States, a return to growth in these areas would be a
positive development for both the dollar and U.S. exports. Over the short-term, our base case
is constructive regarding the U.S. economy, predicated on some favorable trends and catalysts
that continue to drive the current expansion:
Labor market and consumer spending
The U.S. labor market has generated nine million new jobs since 2014 and the unemployment
rate has fallen to 4.1%. This rate is below the CBO’s longer-term estimate of full employment
for the first time in nearly a decade. At the current pace of job growth (roughly 185,000 per
month) the unemployment rate should break the 4% barrier and perhaps go even lower
than the 2008 record of 3.8%. As the jobless rate falls further below the full-employment
threshold, a tightening labor market should lead to stronger wage-price inflation, provide
additional support to consumption spending and domestic demand, and help strengthen
household balance sheets.
Housing market
The single-family housing market is strong, with median prices for single-family homes
increasing by 6.2% over the past 12 months and broad-based metro area home price growth.
Of 178 metro areas for which the National Association of Realtors collects data, 87% showed
year-over-year gains for median single-family home prices. Strength in the single-family housing
market is a positive for household wealth and, in turn, increased consumption spending.
Consumption Expenditures
Spending on consumption has held up well over the course of the recovery, given the weak
trends in wage and income growth relative to prior cycles. As the job market nears full
employment however, income and spending trends are stabilizing. Consumption expenditures
are growing by 2.6% on an annual basis and stand a good chance of improving. Moreover,
household formation and income growth are improving rapidly, along with increases in real
median household income. This latter measure rose by 3.2% in 2016, following a 5.2% surge in
2015 — the first consecutive annual increases since 2007.
Export Growth
Despite protectionist rhetoric from the administration, which threatens both import and export
growth, trade remains an important cog in the current expansion. The U.S. economy stands
to benefit from improvements in manufacturing technology, relatively low, but stabilized
commodity prices, and more favorable exchange rates since the U.S. dollar has moderated amid
a global upswing in growth that has resulted in a more synchronized expansion. U.S. exports
grew by 3.2% over the past twelve months — following a stagnant 2016 — and job openings
for manufacturing positions have surpassed their prior peak in 2001, indicating that a potential
shortage of workers is holding back stronger payroll growth.
5 | Inside Real Estate • November 2017Chapter 1: Continued
Monetary policy will be tighter
The appointment of Jerome Powell to chair of the Fed suggests continuity with existing monetary
policy. Thus, we expect short-term interest rates will be higher at the end of 2018, although we
remain a little skeptical that the Federal Open Market Committee (FOMC) will follow through with
its “dot plot” guidance. Our expectation is for a more tempered increase in short-term interest rates,
accompanied by some balance-sheet reduction (Exhibit 2). In the near term, a tighter monetary
environment, accompanied by modest reduction of liquidity, is likely to result in a slightly higher cost
of capital for real estate investors – especially those with short-term financing requirements. However,
we are not convinced that long-term rates will shift materially higher (i.e., the yield curve will steepen)
given that longer-term inflation and growth expectations remain weak (Exhibit 2). If the long end of
the yield curve shifts higher, it would arguably be in response to stronger growth and inflation – both
generally positive outcomes.
Exhibit 2: Fed expected to reduce balance sheet slowly
Total assets Forecast assets
$5.0
$4.5
$4.0
$3.5
Trillions, USD
$3.0
$2.5
$2.0
$1.5
$1.0
$0.5
$0.0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: Federal Reserve Combined Balance Sheets, August 2017
Flat yield curve suggests longer-term caution
350
300
250
10-year - 2-year spread, Bps
200
150
100
50
0
-50
-100
Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: Federal Reserve, November 2017
Inside Real Estate • November 2017 | 6Chapter 1: Continued
Use of space will continue to evolve
Commercial real estate will continue to see the use of space evolve and adapt to the changing
need of occupiers. Each property type will witness change - some cyclical, while others are more
structural. Perhaps the most visible (and structural) change will be in the retail sector. While the
full impact on brick-and-mortar retail is uncertain, e-commerce continues to take a share of retail
sales from lower-end malls and shopping centers that house mid-level department stores as well
as commodity-type retailers. Conversely, we expect the industrial sector to become even more
deeply integrated into e-commerce supply chains and adapt with newer, nimbler formats. Office
landlords will need to understand the consequences of the growing Millennial workforce, as well
as a transportation system that is likely to evolve rapidly. Luxury multifamily landlords will have to
adapt to moderating occupancy, while lodging owners will grapple with a significant influx of new
supply as well as the growing use of operators such as Airbnb. If there is a constant that the space
market will face, it will be change.
Real estate will retain relative value
We expect commercial real estate to continue to offer reasonably attractive relative value
for multi-asset investors, and the asset class’ cash flow attributes will be especially welcome.
Investment performance will vary across the quadrants, although the broader trend towards
moderate returns will stay in place. The days of double-digit core real estate returns are behind
us and will give way to modest, but perhaps more sustainable, investment performance over our
forecast horizon – largely driven by income growth. Modest but positive total returns from core
real estate should also provide a chance for debt investors to find opportunities across the risk-
return spectrum, though with the accompanying likelihood of tighter spreads and lower returns.
A convergence in performance across core strategies – both debt and equity – suggests that our
ongoing recommendation in being “stock pickers” remains in place.
Remain constructive but brace for uncertainty
A generally constructive outlook for 2018 does not belie the uncertainty that investors face in
the months ahead - be it geopolitics, monetary policy, or U.S. policy concerns. Geopolitical risks
stemming from the U.S. administration’s “America First” policy, along with tensions regarding Iran
and North Korea, have highly unpredictable consequences. In addition, a potential disconnect
with the Fed may tip capital markets into disarray. Further, a failure by the Trump administration
to implement meaningful policy, dovetailed with the unknown outcome of the investigations
into Russian interference in the U.S. presidential elections, potentially has very destabilizing
consequences. However, the likelihood and timing on any one of these risks boiling over is quite
uncertain, which makes 2018 even more challenging from a risk-management perspective. For
investors, the best approach may be to expect the best, but be prepared for uncertainty.
7 | Inside Real Estate • November 2017Chapter 2: Implications for real estate strategy
Chapter 2
Implications for
real estate strategy
The prospect for moderately higher interest rates reinforces our
recommendation that investors focus more on growing NOI and less on
capital appreciation. Going forward, the ability to push rents will increasingly
Going forward, the hold the key to adding value, especially in an environment where the cost of
ability to push rents debt and real estate’s relative attractiveness may look less compelling than
will increasingly hold it has in recent years. Under our base case, higher interest rates need not cause
dislocations in capital markets or significant upward pressure on cap rates, but
the key to adding value. would likely serve as a moderating factor in an already slowing environment
for investment returns.
Investors will want to keep a close eye on the relationship between cap rates
and the 10-year Treasury yield as one barometer of relative value. Despite the
duration of the current cycle, the spread between cap-rates and bond yields
is reasonable. Cap-rates remain healthy and near their long-term historical
averages without overshooting, as we saw during the last two cycles (Exhibit 3).
As such, we are approaching a period where going-in cap rates may reflect
both cash yield on equity and overall returns on an unlevered basis.
With the focus on NOI growth, the recommendation on fresh capital allocation
under the base case is to underweight more cyclically sensitive property types
(e.g., office and lodging) and be neutral to overweight the multifamily sector,
given the annual resetting of rents tied to inflation. We also recommend
maintaining an overweight to industrial, given the secular changes occurring
in the global supply chain, and remain cautious on retail since it faces growing
challenges from e-commerce and a growing bifurcation of formats (commodity
type and essential versus luxury and specialty goods.
Exhibit 3: Low cap rates will put breaks on appreciation returns
NPI cap rate spreads over 20-year average cap rates
Apartment Industrial Office Retail
400
Above zero = cap rate is
300 above long term average
200
100
Bps
0
-100 Below zero = cap rate is lower
than long term average
-200
-300
Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: NCREIF, Q3 2017
Inside Real Estate • November 2017 | 8Chapter 3: A reasonably balanced space market outlook
Chapter 3
A reasonably balanced
space market outlook
Despite the secular and cyclical trends affecting the trajectory of economic growth,
space-market fundamentals are not displaying any imminent or visible signs of fissure.
The job market is perhaps the bellwether of this current cycle in so far as it relates to
commercial real estate demand; hiring remains robust and slack in the job market is at a
10-year low. Supply-side concerns, to the extent that they exist, are moderate and isolated
to markets where significant development has been mostly justified by sustained demand.
Though the pace of overall take-up has slowed from the cycle’s peak, it is enough to keep
vacancy rates in equilibrium and has allowed landlords to press for continued escalation of
leasing rates in most markets. We believe that the remainder of the cycle will be marked
by a steady pace of rent growth increasingly tied to the pace of overall economic growth
with the industrial sector still standing out as a positive outlier in the short-term.
Multifamily
Once a favorite of investors, the multifamily sector has ridden a cyclical high and a
cyclical low, all within the current cycle. Multifamily is now leveling off to more consistent
and positive demand and investment outlook. Opposing, but apparently equivalent,
forces of economic, demographic, and lifestyle headwinds and tailwinds have created
a somewhat uneven but stable apartment market. Rental growth remains at or above
long-term averages because of strong occupancy levels. Rent growth has been supported
by adequate if not robust enough demand to take up the prodigious amount of new
apartment completions. Despite solid demand, the capital markets have viewed the sector
in an ever-waning light, as evidenced by the fact that quarterly transitions have declined
on a year-over-year basis in each of the last four quarters. Data through third quarter
2017, indicates a 7.5% decline in apartment sales volume relative to the same period in
2016, which points to a broader hiatus in sales for commercial real estate rather than a
breakdown in investment volume for the multifamily sector.
Supply has been and remains the biggest challenge to the multifamily sector over the next
12 to 18 months, particularly in the Class A luxury segment. The pace of new deliveries has
turned up in most markets, causing vacancy rates to tick up. Through mid-year 2017, 43 of
the 82 markets tracked by Reis had seen year-over-year increases in vacancy. About three
quarters of these markets are expected to see an increase in new apartment construction
in 2017 over 2016 totals. CoStar data indicates apartments currently under construction
are at more than 4% of inventory, the highest seen since before 2000. Because nearly all
new development is of Class A luxury apartments, that subsector of the market is most
at risk from over-building and weakening demand since affordability metrics, especially in
gateway markets, are stretched. Few if any tenants can afford to rent Class A apartment
units without a roommate or two.
9 | Inside Real Estate • November 2017Chapter 3: Continued
In keeping with the theme of a strong labor market, demand remains robust for
multifamily rentals. Strong demand for rentals has been, and will continue to be, driven
by favorable economic, demographic, and secular trends. As a result, we see a
continuation of the current low vacancy-rate environment that is leading to sustained
rental growth, particularly in the Class B segment of the market, where affordability and
demand metrics coincide. In fact, rental growth for lower-quality apartment units has now
started to pull ahead from that for Class A luxury units, as shown in Exhibit 4.
Exhibit 4: Class A apartment faces challenges
Apartment rental growth
Class A Class B
7%
Year-over-year asking rent growth
6%
5%
4%
3%
2%
1%
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 2017 2017 2017
Source: CoStar, Q3 2017
Another catalyst for the continued demand boom for apartment market is the erosion of
affordability and lack of access to capital in the single-family market. The U.S. is generally suffering
from a dearth of new home construction and a deficiency of for-sale existing homes, leading to
rapidly increasing prices and lowered affordability. Over the past 18 months, the median home
sales price and the Case Shiller repeat sales index of house prices have both risen by a full 10%.
Over the same period, housing affordability declined by 6.5%, according to Moody’s Analytics. As
home prices and mortgage interest rates continue to tick upward, affordability will suffer further.
This will be especially prevalent in gateway cities and coastal areas, where single-family homes are
already the most expensive (Exhibit 5).
Exhibit 5: Gateway affordability declines amid rising home prices
Single family home prices and affordability for gateway markets
Home price growth rate (left axis) Housing affordability index (right axis)
6.5% 6%
4%
Year-over-year Growth in
Year-over-year Change in
6.0%
Case-Shiller Index
2%
Affordability Index
5.5% 0%
Affordability
-2%
still declining
5.0% -4%
-6%
4.5%
-8%
4.0% -10%
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
2016 2016 2016 2016 2016 2016 2016 2016 2016 2016 2016 2016 2017 2017 2017 2017 2017 2017 2017 2017
Note: Gateway markets are defined as including Boston, Chicago, Los Angeles, New York, San Francisco, Seatle, and Washington D.C.
Sources: S&P Dow Jones Indices LLC; CoreLogic, Inc.; National Association of Realtors; Bureau of Census; Bureau of Economic Analysis; Moody’s Analytics,
Principal Real Estate Investors, October 2017
Inside Real Estate • November 2017 | 10Chapter 3: Continued
The demand tailwind for apartment is also intensified by demographic trends that favor
renting as a lifestyle choice among Millennials and increasingly among Baby Boomers
who are opting for a more urban lifestyle. In the shorter-term, Millennials will continue
to choose apartment living as they graduate from college or leave their parents’ homes
to start life on their own. While still burdened with student debt and living on entry-
level incomes, homeownership is at least a few years away for many if not most of them.
Even over the intermediate-term, as Millennials marry and start families in greater
numbers, it is uncertain that they will be able to afford to purchase homes at the same
rate as Baby Boomers or members of Generation X.
Of course, not all markets are created equal. There will continue to be pockets of
supply-demand imbalance, especially in areas where developers choose to build
luxury-priced units that are misaligned with tenant income. We have examined the
top 15 markets that have the most relative new apartment space currently under
construction, and we find them to have varying levels of risk as shown in Exhibit 6.
Exhibit 6: Highest risk apartment markets
High risk: Medium High risk: Medium risk:
High vacancy* X X X
High rents* X X X
High construction* X X X X
South Florida Austin Boston Orlando San Francisco Chicago
Washington, D.C. Charlotte Long Isand Los Angeles
Denver N New Jersey New York
Nashville San Jose
Phoenix Seattle
Salt Lake City
SW Florida
* Higher than the national average
Sources: CoStar, Principal Real Estate Investors, October 2017
11 | Inside Real Estate • November 2017Chapter 3: Continued
Lodging
Our view on the lodging sector has been decidedly on the more cautious end of
the spectrum. U.S. hotel industry fundamentals keep surprising to the upside,
even though demand has been challenged by supply, a strong dollar, and
moderate economic growth. Over the past 24 months, we expected material
weakness, but we have seen continued, albeit moderate, improvements in
hotel occupancy. Our view on lodging, however, has not altered. The stance
is based on two reasons: the large amount of new supply coming on line
and expectations for positive but weaker demand. Despite the nascent
downward trend, demand for rooms has remained healthy relative to historical
comparisons, decelerating only slightly, while new supply was delivered a bit
New supply remains more slowly than expected. For the 12 months ending in September 2017, net
absorption totaled 48,576 hotel rooms, while construction completions were
the biggest headwind
recorded at 60,302 new rooms. Because of the small imbalance, the occupancy
for the hotel industry. rate ticked downward from 72.5% to 72.4% as of third quarter 2017.
New supply remains the biggest headwind for the hotel industry, although
new hotel supply deliveries have been a bit slower than expected over the
last several quarters. In 2014 and 2015, net additions to inventory in the
national hotel market totaled just 1.2% each year. In 2016, new additions
jumped to 1.8%, a volume not seen since 2009. Additionally, we are on pace
to see deliveries accelerate to 2.7% by the end of 2017. While construction
deliveries should decline somewhat in 2018 and 2019, they will still be higher
than any year recorded in the era following the global financial crisis. CoStar
is predicting a cumulative 6.1% increase in hotel stock over the three years
ending in 2019.
Data from Smith Travel Research (STR) confirm the robust outlook for
hotel supply. In August 2017, STR reported there were 1,463 hotel projects
with 192,132 rooms under construction in the United States. This increase
represented a 12.9% uptick from August 2016 levels. In addition, another
3,448 hotel projects with 397,948 rooms were in the planning phases—a 7%
increase from August 2016 levels. Rooms currently under construction and
tracked by STR will increase existing U.S. hotel stock by 3.7% over the next
couple of years. And if all the rooms under construction and in planning are
completed, the total inventory of hotel supply will rise by more than 11%.
Capital market demand in the hotel sector has showed measured weakness
for several quarters. Though this can be seen partially as a function of
headwinds to space-market fundamentals in the sector, it is also part of a
broader trend in commercial real estate, wherein investors have become
more cautious on more cyclical property types. Data through the first three
quarters of 2017 indicate a dollar-volume decline of nearly 23% from the
same period last year. During that same time, the average price per room sold
has declined by 35%, and the average cap rate has remained stable at 7.2%,
according to data from Real Capital Analytics. Year-over-year transaction-
sales volume has declined in six of the last nine quarters for the hotel sector.
Inside Real Estate • November 2017 | 12Chapter 3: Continued
The fact that hotel-revenue-per-available-room (RevPAR) growth, and thus profitability, has been
decelerating for several quarters is yet another cause of slower capital-market demand for lodging.
Despite continued, albeit small, occupancy improvements, average daily room rates (ADR) and
RevPAR growth have been decelerating steadily since mid-2014. By third quarter 2017, year-over-
year growth in each of these metrics was some of the lowest in more than six years. In fact, RevPAR
growth declined to 2.4% in third quarter – the lowest recorded since the end of the recession.
The biggest headwind to improving ADRs and RevPAR growth is the ongoing increase in hotel
construction. But demand issues may also be a detriment. Unlike the surge of construction that
is foreseen to continue (based on projects under construction and planned), demand is expected
to slow by year-end 2017. Several factors are likely to contribute to the deterioration. If the dollar
strengthens (with further Fed tightening), it will create an additional headwind for offshore
visitors. Areas in the southern and southeastern regions may experience a short-term weakness in
demand because of damages sustained in the 2017 hurricane season – although rooms rented to
aid-workers, temporary construction labor, and displaced homeowners may offset some or all the
softness caused by a dearth of business and leisure travelers. In the intermediate-term, hotels that
survived the disaster may see solid growth in occupancy, ADR, and RevPAR because of a limit on
new supply caused by increased construction costs in the area. Our view of hotel is certainly
more measured than it was at this time last year, and we foresee headwinds for lodging, since
new development will prevent more robust occupancy rates and income growth for owners
and operators.
Exhibit 7: Hotel transactions continue to slide
U.S. hotel transactions
Hotel sales (left axis) Average price per room (right axis)
$18
$16 $350,000
$14
$300,000
$12
Billions in sales
Price per room
$250,000
$10
$8 $200,000
$6
$150,000
$4
$100,000
$2
$0 $50,000
Q1 Q3 Q1 3Q Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016 2017 2017
Source: Real Capital Analytics, November 2017
13 | Inside Real Estate • November 2017Chapter 3: Continued
Office
We are cautiously optimistic on the office sector, given its cyclicality and
tight correlation with economic growth and the labor markets. There are
no inherently significant concerns: vacancy rates are in equilibrium in most
markets, demand is stable, and landlords continue to capitalize on pricing
power to move rents higher wherever they have the ability (e.g., Orange
County, Charlotte, Seattle, and Nashville). Leasing velocity, which has been
disappointing in recent quarters, is accelerating modestly as evidenced
Office occupiers today in increasing net absorption through the second half of 2017. We expect
strength in the office-using sectors of the job market, along with higher
are focused on using
corporate confidence, to translate into more demand for space over the
capital expenditures to next 12 to 24 months. Construction is just now playing a role, albeit a minor
attract and retain skilled one, in space-market dynamics because supply has finally caught up to
demand. As a result, both vacancy improvements and rental growth are
employees by enhancing
moderating. Our cautiously optimistic mood is also driven by aggressive
on-site amenities. pricing in gateway markets and the potential for increased cost of capital,
which may weigh on transaction volume and price appreciation.
Continued growth in the labor market, a lynchpin of our expectations for
the economy, is also the driver for expansion of the office demand cycle.
We anticipate the United States to generate two million jobs in 2017, with
office-using payrolls continuing to expand at an annual pace of nearly 2%.
With the economy near full employment, this should be more than enough
to reduce unemployment and, more importantly for the office market,
increase occupied stock and lower vacancy, given current supply trends.
We are cautious because overall office demand remains weaker than
we might expect at this stage in a typical cycle. This is at least partially
explained by secular trends toward denser use of space, the move toward
alternative working arrangements, and smaller and shared work spaces.
The space-per-worker factor is an example of how this might be affecting
demand. In each cycle dating back to the 1980s, each office worker was
associated with 250 square feet of net absorption, including single-tenant
stock assumed to be fully occupied. Since 2010, however, that figure has
been reduced by more than half to 120 sf per worker. Although there is
some evidence that suggests occupiers have become increasingly price
sensitive when it comes to office leasing, companies are not necessarily
transitioning to smaller work spaces simply to cut costs. Rather, office
occupiers today are focused on using capital expenditures to attract and
retain skilled employees by enhancing on-site amenities: improved common
areas, kitchens, and on-site services such as fitness centers.
Inside Real Estate • November 2017 | 14Chapter 3: Continued
Exhibit 8: Suburban office demand is healthy Location is also playing an important role in current
Downtown vs. Suburban: Share of total net leasing decisions, particularly in the choice between
absorption in last 12 months downtown and suburban submarkets. The popular
Suburban share narrative suggests that to attract Millennials,
Downtown share employers need to be in popular, trendy, and
Share of total net absorption in last 12 months, % often expensive urban locations. Despite this
0 10 20 30 40 50 60 70 80 90 100 theory, which also foretells a secular decline in the
Boston suburban office market, the data suggest that is not
Dallas
necessarily (or not always) the case. In fact, some
well-located suburban submarkets have started
San Jose
to outperform their downtown counterparts,
Baltimore particularly in coastal gateway cities and high-
Denver tech markets. In these areas, companies look to
revitalize existing space or develop more modern,
Las Vegas
custom workplace environments. The alternative
Phoenix is housing their workforce in cost-prohibitive, older
Sacramento buildings located in the traditional financial districts
of such cities as Boston, New York, Philadelphia,
Austin
and San Francisco.
Orlando
Raleigh Not all suburban locations are created equal;
those that we expect to outperform will be well-
Charlotte
connected to urban centers to maximize access to
Washington, D.C. both labor and amenities. Historically, suburban
Detroit office assets have tended to outperform later in
Columbus
the real estate cycle since both investment dollars
and demand look for relative value when yield
Kansas City
spreads tighten. We feel this cycle is no different,
Los Angeles particularly as overall trends in the office market
Atlanta are moderating.
New York
One area where we are seeing some contradiction
Seattle to the broader moderation in the office market is
the supply pipeline, which remains poised to hit
Source: CBRE EA, Principal Real Estate Investors, Q3 2017
its cyclical peak in the next 12 to 18 months. We
anticipate 119 million sf of new office space to be
delivered by year-end 2021, which will increase
overall net rentable area in the national office
market by 2.8%. This is not extraordinarily high by
Historically, suburban office assets have tended historical standards and much of the development
activity is slated to occur in the top-five markets,
to outperform later in the real estate cycle.
many of which have quite low levels of vacancy and
a need for more modern office space.
15 | Inside Real Estate • November 2017Chapter 3: Continued
Exhibit 9: Office supply concentrated Concerns over the uptick in development are most
Office projects under construction by year clearly seen in the gateway markets (see Exhibit 9),
especially the West Coast markets like San Francisco
2017 2018 2019 2020 2021
and San Jose, where pockets of weakness on the
U.S. Market Average
demand side have pushed vacancy rates higher over
0 2 4 6 8 10 12 14
the past 12 months. However, we are approaching a
New York
cyclical peak in supply partly because of the lack of
available debt to fund projects without healthy pre-
San Francisco leasing requirements, as well as a rapid increase in
Washington, D.C. constructions costs. Even with somewhat constrained
supply, a moderate outlook for demand would create
Dallas
a situation where vacancy rates would eventually
San Jose start to increase. So far in 2017, landlords have been
able to exercise pricing power. But in many markets,
Seattle
that freedom has been accompanied by large and
Denver growing tenant-improvement and capital-expenditure
Managed square feet, millions
allowances. Healthy but moderate payroll growth in
Boston
our base-case forecast will keep demand positive and
Los Angeles vacancy at equilibrium over the next year.
Atlanta
Capital markets are also at an inflection point.
Chicago Spreads on office yields have compressed to
Austin their lowest levels in the cycle and core office in
many markets is priced for perfection, making it
Houston
increasingly difficult to find value. Sales volume for
Raleigh office properties has dropped 22% compared with
last year—a continuation of the slide we have seen
Philadelphia
since office sales peaked in 2015. While the decline
Orange County in office volume is a reflection of the overall trend in
commercial real estate across property types, it is also
Oakland
reflective of our view regarding the moderation of
Charlotte income and appreciation returns for the property type
Miami at this stage in the cycle.
Baltimore
Our outlook over the next year forecasts a similar
Phoenix trend for 2017: more moderation for most segments
of the market. Slow but steady leasing—even
Portland
factoring in potential acceleration—will keep rent
Detroit growth positive and ahead of broader inflationary
trends. The lack of meaningful inflation to date and
Oklahoma
late-cycle demand dynamics mean that the rent
spikes sometimes experienced in long-duration cycles
Source: CBRE EA, Principal Real Estate Investors, Q3 2017 are likely to be limited to a few markets. Investors
should also expect office appreciation to slow and
total returns to be in the mid-single digits (on an
unlevered basis) for 2017, with a good chance of
trending lower over the next two years.
Inside Real Estate • November 2017 | 16Chapter 3: Continued
Retail
No sector represents the nature of the current economic expansion better than
retail. Sellers of essential items and discounters continue to hold their own against
a rising tide of e-commerce, while older store formats and tenants that sell
commodity-type items are struggling to survive. In the midst of this structural
transformation, 2017 has witnessed not only a record number of announced
store closings, but also increased media attention to the issue. With most news
reports proclaiming the imminent death of physical stores, the retail sector’s
overall appeal has been indiscriminately lowered and it appears investors have
decided to throw out the good with the bad. While most stories point to the rise
of e-commerce as the single-most important factor in explaining the headlines,
The retail sector’s some additional issues have exacerbated the industry’s overall adverse outlook.
overall appeal has These issues include declining store productivity, demographic headwinds,
and subpar economic growth. All this activity is against the backdrop of an
been indiscriminately
unprecedented gap in wealth and income distribution that has left the middle
lowered and it appears class more depleted than it has been in decades.
investors have decided
As shown in Exhibit 10, there has been a decades-long decline in shopping center
to throw out the good
sales per capita. At the same time, however, the supply of leasable retail space has
with the bad. continued to grow (a not so obvious issue during prior economic cycles). Since the
1990-1991 recession, the U.S. shopping center gross leasable area saw consistent
growth until the global financial crisis. Since then, both supply and demand for
retail space has been subdued, forcing property owners and tenants alike to
rethink their positions in the face of declining store productivity, partly brought on
by decades of overbuilding. Retailers have reduced both the number and footprint
of stores; old supply has been taken off line and new supply has been muted.
As a result, retail vacancy rates have remained relatively flat across most center
types through the cycle, despite weak demand for space. Rent growth has also
moderated over the past 12 months, but remains largely on pace with broader
consumer inflation, a testament to the resiliency of the sector.
Exhibit 10: Declining store productivity driving store closure post-recession
Retail productivity: too much space – not enough sales (market adjusting)
Retail SF per capita (left axis) YoY Shopping center sales per capita (right axis) Linear (YoY Shopping center sales per capita) (right axis)
2.50% 25%
Shopping Center GLA* per capita
2.00%
YoY Shopping Center Sales per Capita
20%
1.50%
15%
1.00%
10%
0.50%
5%
0.00%-
0%
-0.50%
-1.00% -5%
1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015
*Gross leasable area
Source: ICSC, Principal Real Estate Investors, September 2017
17 | Inside Real Estate • November 2017Chapter 3: Continued
The internet has intensified an already competitive retail landscape. It is worth noting that most
of the announced store closings and bankruptcies to date have been concentrated in apparel,
highlighting an ongoing risk for retailers of commodity-type goods. Given the cost involved with
developing an efficient omnichannel strategy with the needed distribution channels, margins
are expected to remain under pressure along with demand for retail space, as industry players
experiment with different size formats and layouts.
At the same time, risk for grocery-anchored retailers remains elevated; rising demand for prepared
foods highlights format considerations. Many grocers are thus reducing canned food aisles in
favor of pizza stations and sushi bars. Pressures from online grocery shopping have mounted
with Walmart’s investments in dozens of food distribution centers to support its grocery-delivery
business. The company announced that it anticipates online sales growth of 40% by 2019.
Interestingly, the best case for retail properties was made by Amazon’s acquisition of Whole Foods,
highlighting the critical role that physical stores play in any consumer-centric distribution network.
As shopping centers struggle to reverse a decades-long decline in traffic borne from the
lackluster performance of department stores across the country, many have turned to
restaurants and entertainment to diversify their tenancy and maintain consumer traffic. Exhibit
11 below is supportive of this strategy, with food services on a recovery path since the recession,
while deflation in clothing and footwear continues to plague the apparel industry. Experience-
orientated tenants have provided some defense against e-commerce encroachment and
should continue to do so, assuming thorough underwriting, given the restaurant industry’s own
challenges in recent times.
Exhibit 11: Experience-oriented tenants pick up retail slack
% Share of non-durable goods and services (nominal excluding gas)
Health Linear (Health)
Clothing & Footwear Linear (Clothing & Footwear)
Food Serv. & Recreation Linear (Food Serv. & Recreation)
Personal consumption expenditures, United States
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
Source: Bureau of Economic Advisors, September 2017
Inside Real Estate • November 2017 | 18Chapter 3: Continued
The escalation in healthcare costs points to an additional opportunity for property owners to drive traffic to
their centers as Baby Boomers and Generation Xers alike require more doctor visits and lab tests. The Affordable
Care Act has led to a spike in the number of insured people in the United States, which led to demand growth for
retail space as more urgent care facilities opened. Uncertainty wrought by policy dissonance in Washington and
Amazon’s recent interest in the drug-delivery business could present demand headwinds to certain medical-retail
formats. These headwinds will most likely be mitigated by strong underlying drivers of healthcare demand, such as
aging demographics and the relatively inelastic nature of the demand for healthcare.
While Generation Xers, now in their peak earning years, and Baby Boomers, with their accumulated wealth, are
expected to continue supporting retail consumption via physical formats, Millennials’ impact in the medium-to-
long term is less obvious. In comparison to previous generations in the same age group from prior decades, today’s
younger workers are more likely to live with roommates or at home with parents to make ends meet (Exhibit 12).
The implication is quite negative for traditional big-box, middle-income retailers such as JCPenney and Macy’s,
due to the hollowing out of the middle class. In contrast, value retailers such as Walmart and Dollar Store have
been ramping up store openings despite secular and cyclical retail headwinds. The divide between traditional
retailers, who sell commodity-type goods that service the middle-class, and value-oriented retailers, who service
lower-income demographics, is emblematic of the increase in income and wealth inequality in the United States.
Underwriting location and tenant performance will be even more critical in the current environment.
Demographic trends, as well as the income and wealth gap, are likely to continue to drive a wedge between
types of tenants, with those serving the middle market facing the most pressure. Grocery-anchored retail is
expected to remain relatively stable, but pricing and format risk need to be factored-in. Non-market-leading
merchants who sell commodity-type goods remain vulnerable. Omnichannel demands and competition are
likely to put margin pressure on credit quality.
Despite the secular and economic headwinds facing the sector, investors should continue to carefully scour
the landscape for formats and credits that can coexist with the continued growth of e-commerce, as well as
navigate the complex economic environment. It is premature to anticipate the death of retail, but one must
recognize that the retail landscape is in the midst of profound change.
Exhibit 12: Secular income trends could have negative impact on retail
Prime age workers between 18 and 34 have are facing significant headwinds
Living with a parent, age 18 to 34 Living in poverty, age 18 to 34 Median earnings for full time workers, age 18 to 34
35% $38,000
Median earnings for full time workers, age 18 to 34, SD
Living with parent or living in poverty, age 18-34
30% $37,000
25%
$36,000
20%
$35,000
15%
$34,000
10%
5% $33,000
0% $32,000
1980 1990 2000 2009-2013
Source: U.S. Census Bureau, December 2013
19 | Inside Real Estate • November 2017Chapter 3: Continued
Industrial
Fueled by growing e-commerce sales and a reinvented supply chain, the industrial sector
remains at the head of the class. Fundamentals for industrial space are strong since demand
for space continues to outpace new supply and the national availability rate has fallen 670
basis points since 2010. Conservative lender requirements and disciplined debt markets
have kept completions below the long-term historical average over the past several years,
pushing rents higher in what is a landlord’s market. Although it appears that the supply cycle
is poised to more than offset strong demand and push vacancies higher, pent-up demand
and low levels of availability on quality assets should keep space markets fundamentals
strong over the next year.
Factors fortifying demand for industrial space over the forecast include a tight labor market,
a potential pick-up in consumer spending, and secular changes in supply chain and retail
logistics. The industrial property type’s ties to open, global trade should help support the
outlook despite nationalist rhetoric coming from the White House. As the cycle matures,
the headwinds facing the industrial market are likely to be tied to the duration of the
current expansion, slowing growth, tightening capital markets, peak pricing, rising land and
construction costs, and uncertainty in political policies. Taken together, these headwinds will
not derail the progress made to date, but will certainly lead to more moderate growth over
the longer-term.
Availability in most markets is below levels seen before the global financial crisis, while
industrial space under construction for the nation has averaged just 0.8% of inventory per year
since 2010. Peak occupancy and robust rental growth have stoked the supply pipeline, and
speculative construction has increased, bringing industrial space under construction back to
its long-term average of 1.5% of total inventory over the last twelve months (Exhibit 13).
Exhibit 13: Industrial supply cycle has picked up steam
Industrial supply
Under construction (left axis) As a % of inventory (right axis)
250 1.6%
1.4%
200
1.2%
150 1.0%
% of inventory
Millions of SF
0.8%
100
0.6%
0.4%
50
0.2%
0 0.0%
Q1 2007
Q4 2007
Q3 2008
Q2 2009
Q1 2010
Q4 2010
Q3 2011
Q2 2012
Q1 2013
Q4 2013
Q3 2014
Q2 2015
Q1 2016
Q4 2016
Q3 2017
Sources: CoStar, Principal Real Estate Investors, Q3 2017
Inside Real Estate • November 2017 | 20Chapter 3: Continued
Under-supply and pent-up demand notwithstanding, the anticipated
volume of new deliveries over the next 12 to 24 months may impact
landlords’ ability to push lease rates higher. As a result, industrial rental
growth is expected to moderate over the next few years (Exhibit 14).
With substantial new construction activity in major industrial locations
(e.g., the Inland Empire, Lehigh Valley, Chicago, and Dallas), landlords in
those areas will face the most significant challenges.
Demand for industrial
Demand for industrial space is also becoming more nuanced because
space is also becoming tenants are looking for vastly different characteristics than they
more nuanced because were just a decade ago – an issue that is affecting lease rates and the
tenants are looking take-up of space. Rapid increases in land prices in locations linked to
intermodal transportation, as well as labor shortages in many markets,
for vastly different
are prompting occupiers to look to expand their geographical horizons
characteristics than in order to meet these competing needs. Amazon, for example, believes
they were just a the middle-mile is just as crucial to e-commerce as the last-mile, and
continues to look for additional delivery capacity and greater control
decade ago.
over their line-haul operations. The result is Amazon’s announced plans
for 24 new fulfillment centers in 2018, in addition to new sortation
centers just outside large urban centers in various states.
Industrial availability is well below what it was before the global
financial crisis. As a result, new warehouse property is scarce enough in
many regions that tenants are getting more creative in order to meet
space requirements. Buildings that were once considered obsolete are
now being repurposed by e-commerce companies that see value in
Exhibit 14: Industrial rents are still rising
Industrial national forecast July 2017
$/SF rent (left axis) Growth rate (right axis)
$8 9%
$7 7%
$7 5%
Per sf, triple net expenses
3%
$6
1%
$6
-1%
$5
-3%
$5
-5%
$4
-7%
$4 -9%
$3 -11%
1988 1992 1996 2000 2004 2008 2012 2016 2020 (f)
Sources: CBRE EA, Principal Real Estate Investors, Q3 2017
21 | Inside Real Estate • November 2017Chapter 3: Continued
refurbishing older facilities for cost-effectiveness of urban infill locations
and last-mile operations. While the size and location of facilities have
diversified because of changes in the logistic supply chain, all subtypes will
be driven by the end-consumer. Big-box distribution centers will continue
to require the newer and improved characteristics and technology,
whereas some of the formerly obsolete, vintage, Class B properties in the
urban core may provide a different edge in the industrial market.
Even as the economy
The transformation of the industrial sector from one dominated by
continues to expand,
traditional warehouses into a market characterized by modern logistics
albeit at a more hubs serving the burgeoning e-commerce business has attracted a great
moderate pace, rising deal of capital, and has compressed NCREIF industrial cap rates below
their pre-2008 nadir. However, spreads have remained wide relative to
construction costs and
the other major property types and, along with strong space market
labor shortages may fundamentals, have attracted capital to the sector. From a relative-
temper new supply. value perspective, overall industrial values (as measured by the NCREIF
appreciation index) are now 6.6% above the prior peak, but lag those for
retail and multifamily (Exhibit 14).
It would not be surprising for the industrial sector to see further value
growth, given the secular changes in demand for this property type and
industrial’s increasing attractiveness to global investors in search of stable
long-run returns. Additionally, even as the economy continues to expand,
albeit at a more moderate pace, rising construction costs and labor
shortages may temper new supply over the long-term and help rental
growth and pricing trends to remain positive.
Exhibit 15: Industrial appreciation may have upside
NPI value change by property type
Peak-to-trough Current relative to peak
20% 17.5%
9.7% 8.8%
10%
4.3%
0
-5.9%
-10%
-20%
-25.0%
-30%
-31.5% -31.6%
-32.8%
-40% -34.2%
Overall Retail Office Apartment Industrial
Sources: NCREIF, Principal Real Estate Investors, Q3 2017
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