Research article

US investment outlook – dealing in uncharted waters

New York looks at how political issues may play out for America’s real estate

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Barring some shock to the global economy, 2017 will bring yet another year of strong investment sales in the United States. However, the outlook for 2018 and the years beyond is murkier. As well as an increased chance of a recession, the populist and nativist shift seen not just in the US and the UK but also, most recently, in Italy, is a long-term concern. Voters have expressed their discontent with globalisation, among other things. Donald Trump’s victory defied forecasts and his embrace of an “unpredictable” approach to policy will make it challenging for foreign leaders and investors to plot their strategy.

While investors were initially a bit dazed by the result, some have become increasingly enthused. Like the electorate, many pundits and analysts are deeply divided about whether Trump will boost or botch things. The first 100 days may clarify whether his administration is going to take a combative and confrontational stance or a constructive and conciliatory one.

An unchecked confrontational Trump administration might pursue aggressive trade negotiations and arms talks with perceived foreign competitors (China, Iran and others) and vendettas against old domestic political foes. There could be clear winners and losers and the US could see a level of political patronage rivalling that of the 1920s and 1870s. Countries and companies that cooperate will get benefits. Similarly, mayors and governors who get on board with a long list of planned reforms (immigration, repealing the Affordable Care Act (Obamacare) and tax reform) will also gain. Those who do not could very well see federal funding for some programmes cut. For investors, there could be big differences between picking the right geography and the wrong one.

On the other hand, investors are getting excited about the potential for Trump, together with Congress, to forge ahead with constructive legislation and ‘pro-growth’ measures that could provide some stimulus to the economy. A major infrastructure bill, positive immigration reform, the privatisation of Fannie Mae and Freddie Mac, corporate tax reform and lower income taxes could boost corporate investment, construction activity and household spending power. Defence and national security spending could also spike. A turn in this direction could boost sectors such as banking, housing, defence contractors and construction.

"In the longer term, it would take extreme disruptions to erode the bedrock underlying the value of residential and commercial real estate across much of the US"

Keith DeCoster, Savills Research

So far, President-elect Trump seems to be taking a combative stance – sparring on Twitter with China, the CEO of Boeing, union leaders, and a long list of newspapers and networks. Most recently, he has levelled his aim squarely on US corporations guilty of offshoring operations. This may just be meaningless social media banter, but it could already be giving Chinese funds second thoughts about buying American.

A few Chinese investors may already be holding off on real estate investments in the US and considering alternative investments closer to home. It is worth noting that the US is already slapping Chinese steel with tariffs, but an escalation in disputes could spell trouble for what has been a very potent source of cross-border investment. Chinese investors attracted to the security of Manhattan real estate were willing to pay top dollar for assets with negligible yields. They have dominated condo acquisitions in Manhattan via the EB-5 program. Chinese and Middle Eastern sovereign wealth funds have provided substantial funding for some of the largest developments under way in the US. This includes Manhattan’s Hudson Yards as well as Oyster Point in South San Francisco, one of the biggest biotech developments globally.

On the bright side, even if Chinese and Middle Eastern funds, two of the deepest pools of cross-border capital, rein in some of their US purchases, it may just clear the way for other countries still very eager to invest in the US. Other foreign investment firms have set up funds targeting US real estate assets just in the past few weeks. Tokyo-based Mori Trust Co, for example, announced that it plans to invest $7 billion globally, with much of its focus in the US. It initiated expansion by acquiring two office buildings in Boston.

In the longer term, it would take extreme disruptions to erode the bedrock underlying the value of residential and commercial real estate across much of the US. There is little left that is still sacrosanct to American politicians – property rights remain one of the most enduring principles. Capital is not truly blind, though. Chinese banks and funds can be easily told to steer their investments elsewhere.

More importantly, human capital has shown that it will make clear choices. A turn inwards by particular cities or a wider societal turn against particular religions or lifestyle choices can have economic and real estate consequences. Many US cities have thrived in recent years because of the quality of life and distinct offerings they make to incomers. In turn, this affects which companies will operate in them and who will live there. People, as well as businesses, are already making cultural and political investments – some silently, others much more vocally. In the global war for talent, it is eminently possible that other cities, both within and outside the US, can win some of these battles.

Global mega-cities are capturing a disproportionate share of higher-paying jobs and investment activity. The renaissance of urban cores as walkable and liveable settings and major tourist/retail destinations has depended on public safety first, the return of talented and skilled people, extensive residential and retail development and then office tenancy. The most highly prized labour and property in the US (and hence globally) is connected to a set of skills, values and culture that can be characterised either as a positive ‘global/progressive’ force or negatively as ‘elitist/foreign’. How these cities continue to be perceived could have a major impact for investors.

The US is riven by a deep rural and cosmopolitan divide. The recent calls for a focus on ‘law and order’ could provoke unrest in some US cities. Lastly, a populist and nativist turn inwards, in the name of repelling a torrent of foreign workers, as well as terrorists, from crossing borders, threatens the flow of investment and human capital that many mega-cities depend on. Investors in US cities will do well to watch the way the political wind is blowing – there may be squalls on the horizon.

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What happened in 2016?

Real estate investment volumes are down in the US. Even before the election, transactions were running just a bit below their 2015 levels. But it was probably a bit much to expect investment sales to match 2015’s stellar volumes, which had been driven by some massive portfolio and entity-level sales.

In November, office sales totaled $99.5 billion, 7% below 2015 levels. Entity-level and portfolio sales were down by more than 40% from a year previously, but a burst of secondary and tertiary market activity filled much of the gap. The biggest drops have been seen in offices and multi-family transaction levels. Investors have shown some price resistance to sub-5% cap rates in the biggest metro areas and concerns that the multi-family sector may be getting overbuilt.

The pool of investment capital pointed at the US is still deep. Even if Chinese and Middle Eastern funds were to withdraw, other foreign investment firms would likely step in. Other overseas investors have set up funds targeting US real estate assets just in the past few weeks. Tokyo-based Mori Trust Co, for example, announced that it plans to invest $7 billion globally, with much of its focus in the US, and it has acquired two office buildings in Boston.

Institutional investors and REITS have backed away from some, but not all, the top gateway markets. As we predicted, secondary markets with integral links to tech and strong long-term demographic trends were clear winners in 2016. Austin investment sales were up by 21.2% (at $1.4 billion), Charlotte by 64.3% ($1.2 billion) and Richmond by 79.6% ($541 million).

Additionally, other investors priced out of the core gateway markets, sunk their money into alternative locations just outside core areas. San Francisco’s East Bay saw investment activity increase by 74.7%, (to $2.0 billion) and Northern New Jersey was seen as an alternative to Manhattan, with investment activity up 27.2% (to $2.9 billion).

"Trophy assets in gateway markets – Manhattan; San Francisco; Washington, DC; Boston; Chicago and Los Angeles – are still the gold standard for capital preservation"

Keith DeCoster, Savills Research

Core-plus (long-term holds with sterling tenancy and ironclad cash flow)

Uncertainty and turbulent equity markets could lead cautious investors to focus on core assets and markets, taking some of the wind out of the sails of secondary and tertiary markets.

Trophy assets in gateway markets – Manhattan; San Francisco; Washington, DC; Boston; Chicago and Los Angeles – are still the gold standard for capital preservation. Investors should note that growth is at or near peak for net operating income in the highest-calibre offices, Multi-family residential and retail properties in SF, NYC and Washington. Rising tax and concession costs will further erode the bottom line or landlords over the next few years. In the short term, Boston, Chicago and Los Angeles still have some potential for more rental growth.

Cap rates and yields have been rising since the election, so those who bought in the past two years may have done so at the top of the market. Some long-term holders of core assets in offices and multi-family in Manhattan and San Francisco cashed out at this time to turn some of their gains to other markets.

Core (Class A office in high-growth Sunbelt markets)

Investors will still be able to capture higher yield in the short-term for core assets in Sunbelt markets such as Atlanta, Dallas/Fort Worth and Phoenix, as well as some tertiary markets such as Nashville and Salt Lake City. These markets offer pricing that is still generally well under $300/sq ft. Cap rates are generally 200 to 250 basis points above those in core gateway markets. Metro areas such as Raleigh/Durham, Nashville and Austin often only have a limited number of trophy assets. In turn new construction has performed very well, particularly as companies from larger metro areas come into the market and open up operations.

Investors need to carefully consider the extent to which secondary and tertiary markets have truly diversified their industry base. In the event of a 2018 or 2019 recession there is the potential for a ‘snapback factor’ in metros that have a lot of back office and support services. Office and multi-family properties in these markets could see a jump in vacancy a couple of years from now if companies decide to consolidate support and administrative jobs back to their home base, much as most oil and gas firms have done. Some markets, such as Atlanta and Dallas/Fort Worth, have matured and may not see as big a cyclical retraction of jobs. This phenomenon can be industry specific, with housing and lending firms more likely to consolidate than fintech or biotech, which are likely to remain linked to specific labour pools.

Value add (Refurbished office and multi-family product)

Talented workers and in turn, major employers, are moving to urban cores or ex-urban locations. Atlanta, Raleigh/Durham, Nashville and Austin have all seen rent reach record levels in core urban submarkets. This sets up opportunities for landlords leasing older second-generation A-/B+ office space to highlight the price gap between their asset and the top of the market. Class A rents are not likely to fall much until 2018 (in Manhattan and San Francisco) and possibly later in Boston, Los Angeles and Orange County. In turn, Class B buildings in these markets continue to enjoy increased occupancy and elevated NOI. Buildings that can be converted to creative office space, or those with large open floor plates, are in demand across Southern California. Investors who acquired warehouse buildings or older Class B office properties and converted them to creative office space have captured a strong return on their investment. In some cases landlords were able to leave the build-out to a well-funded tech firm, further padding their gains.

Value add (Close-in suburban office in Northeast/Northwest, surban sunbelt mixed-use)

The cap rate gap between CBDs and suburbs will continue to narrow a bit in 2017, as pricing for suburban assets in Sunbelt and Southwest markets increases. Investors in the Northeast and Midwest should continue to follow migration patterns to CBDs and close-in suburban areas. Circa-1980s and 1990s suburban office parks on the outer ring of cities in the Midwest and Northeast represent major risks as they struggle with tenancy loss and a depreciation in asset values. Suburban office complexes in Midwest and Northeast with access to mass transit and nearby retail/prime housing have fared better, but in markets such as Northern New Jersey and Suburban Chicago where landlords have incurred significant renovation and lease-up/concession costs. Office building sales volume in suburban Midwest markets totaled $5.5 billion, with an average price of $130/sq ft.

On the other hand, there is still a demographic upside to suburban locations in the Southwest and Southeast. Investors have clearly already realised improvement in fundamentals – metros in the Southwest captured $10.6 billion in sales with an average price per square foot of $189. Dallas alone tallied $4.3 billion in sales.

Dallas, Phoenix and Atlanta could soon be testing the limits of demand for ‘surban’ mixed-use community development on the periphery of their metros. These massive, mixed-use communities try to replicate the live/work/play setting of an urban core and have successfully signed major corporations such as Toyota, State Farm and Mercedes Benz to new build-to-suit office properties. Housing costs are typically much lower than in urban submarkets but millenials may ultimately still prefer Atlanta’s Buckhead to an Alpharetta or Sandy Springs.

Multi-family is at risk of being overbuilt in some of the fastest-growing metros such as Atlanta and Tampa Bay as well as luxury product outside Washington DC. Demand projections for multi-family product depend on the assumption that Millennials will continue to rent at much higher proportions than previous generations. Historically, though, legislation that encourages home ownership, either through cheaper financing or tax credits, has been a recurring features as legislators both at the state and national level try to jump-start the economy. While this seems inconceivable given the excesses of the last recession, the recent calls to privatise Freddie Mac and Fannie Mae, and to repeal Dodd Frank, could be a bridge back to this. Multi-family development in some secondary markets such as Nashville and San Antonio has been more restrained. This leaves room for investors to acquire older 1980s and 1990s communities and spruce them up with new amenities and updated appliances. Some older, garden-style apartment complexes have commanded price per unit in excess of $100,000 per unit – a fraction of the $500,000 per unit for top buildings in Manhattan, but a high mark for sales in some secondary markets.

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Opportunistic (Port/logistics and infrastructure-related)

Final mile industrial and port/logistics:

Among the major asset groups the industrial sector has the strongest fundamentals. The ecommerce revolution and growth in the logistics/supply chain have pushed vacancy to its lowest mark on record. This sector has more potential for rental rate growth. Distribution centres in key logistics/transportation hubs have become core assets. The choicest warehouse/distribution centres already changed hands in 2014 and 2015. Investors will have to shift their focus to final-mile locations or redevelopment opportunities in the industrial sector.

This sector could benefit from several pro-growth initiatives that have a chance of making it through Congress. A major infrastructure bill, coupled with corporate tax reform, could provide a short-term burst in investment in both equipment and manufacturing facilities. Talk of moving ahead with the Keystone pipeline and to bring back “a drill, baby drill” environment could spur demand for warehouse and flex facilities in the oil-patch and Plains states. Industrial land could also benefit, particularly sites within driving distance of major ports and logistics. Informed investors should keep a close eye again on whether an infrastructure bill takes on a ‘most-favoured’ state approach in which rural states are rewarded with the biggest piece of shovel-ready funding, or if a simple ‘spread the wealth’ approach that benefits major metros is pursued. Finally, rather than adding to the deficit, Congress may choose to take a public-private approach by selling PPP opportunities to the highest bidder. Investors in PPP infrastructure development need to be careful – some of these have proved to be unprofitable.

Any major shift to protectionist policies will encounter resistance from Congress. Nevertheless if there is a clear change to a ‘Buy and build America’ policy it will threaten to disrupt the supply chain. This would create major disruption for small business owners and manufacturers that sell products overseas. This includes high-tech manufacturing and agricultural equipment, such as Caterpillar. There would be some very clear losers if a trade battle ensues. Seattle for one – two of its top firms, Boeing and Apple, derive most of their profits from sales overseas.

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Suburban Washington, DC has become one of the softest markets nationally as mistimed new construction and weakening demand has pushed availability above 20%. Nevertheless, betting against the reality that Washington, DC always grows is a long shot. A turnaround in select agencies may not be far away. Despite the likelihood that a Trump administration may savage spending for some agencies such as the Environmental Protection Agency, Department of Education, Department of Health & Human Services and Department of Labor, it seems apparent that funding for defence, homeland security and the FBI/Justice Department could balloon. This may have implications as well for markets that have seen either a freeze or cutbacks in defence spending in recent years, such as Fort Worth, Texas and Bridgeport, Connecticut.

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