Opportunity in a changing market

(approx. 3 minutes reading time....)
 

RSM national real estate leaders Stu Taub and Troy Merkel sit down with Preqin to discuss the hottest real estate sectors, Opportunity Zones and where in the US investors are likely to see some big plays.

Preqin:  How attractive is the real estate market looking right now?

For around two years now, the consensus has been that we’re late in the cycle. But looking at the underlying fundamentals and the amount of capital that’s entered the market during this time, we’re seeing that the current cycle still has some legs left.

But we have seen change in the market. Capital will always shift around as industry players look to new markets in search of opportunity. Recently we’ve seen changing macroeconomic factors at play in real estate, but many of these factors have led to increased activity in the market.

Take the tariff and trade discussion in the US. As investors look to be more conservative and position themselves away from the public market, they look to real estate. In the year to May 2019 we’ve seen property valuations up 15%, compared to the S&P 500 which is down 10% over this period. We’ve also seen interest rates level off and look to be holding at the current rate, or maybe even going down a little, which helps significantly within the real estate market.

So yes, we’ve seen a prolonged period of growth. But there's a lot of strong fundamentals showing that real estate overall, and more specifically in the US, is in good health.

“We’ve seen a prolonged period of growth, but there’s still a lot of strong fundamentals showing real estate is in good health."

Preqin:  You mentioned the tariff and trade discussions going on in the US. Has this affected the real estate market?

There isn’t a huge impact on the real estate market here, certainly from a tariff point of view.

However, one thing we are seeing is that there is an almost hidden change currently being seen in the flow of capital into US real estate. We’ve seen a reduction in the amount capital entering the market from China-based investors but because of how attractive US real estate remains, investors from Canada and the EU have come in and filled that void.

So even though there's that hidden equity war within the trade war, we have other countries that are filling that gap and maintaining the valuations that we see in US real estate.

Preqin:  Which real estate sectors are hot right now?

In terms of traditional core investing and steady cash flow, the hottest markets right now are multi-family, senior housing, healthcare and industrial. Although you have to be careful when you talk about the industrial market – really the attention is specifically logistics.

Industrial can be seen as a couple of different asset classes. You have logistics and distribution, which is the area most exposed to e-commerce, hence the greater attention from investors. You also have traditional manufacturing, data warehouses, storage warehouses and manufacturing plants. The point here is that not all these industrial sectors provide the appropriate risk/return for core investors. Institutions seeking core opportunities in industrial will largely target logistics, and that is the growth market.

If you look at the value-add and the opportunistic markets, then you see a lot of office transactions. A big trend we’re seeing in the market is the repositioning of office assets to be flexible work space, creating an open-space, entrepreneurial-type concept.

Outside of office, we’re seeing movement in retail. Not necessarily your big-box retailers, but that next-class retail, where it's more of a scatter site and managers can look to create an experiential center. This of course brings risk, but we’re seeing strong returns in this sector.

Preqin:  What about Opportunity Zone regulations – how is it shaping the US market?

In some respects, Opportunity Zones have been seen as a way to improve the terms and attractiveness of a deal that was likely to be completed without the regulation. If you look at the location of some of these Zones in areas such as Portland, Nashville, Denver or Los Angeles, these areas were already in the path of development before Opportunity Zones came into play, simply because the regulation was created using data stretching back to 2011.

There’s a lot of demand for Opportunity Zone strategies and there's empirical evidence that property prices in some of these Zones have been outpacing the non-Opportunity Zone development projects in the last few years. When looking at actual activity in these Zones though, you can see activity has recently spiked.

One driver is that, until recently, it’s probably fair to say Opportunity Zones had been largely considered ‘hype’, but when the new set of regulations came out in April 2019 we saw them land significantly on the side of investors, so much so that the program is probably one of the most investor-friendly initiatives to come out of the IRS in a long time.

Another driver of recent activity is the 180-day window investors have to reinvest any realized capital gains into a Qualified Opportunity Fund. Many investors access real estate via LLC structures with capital gains realized on 31 December 2018. This puts the 180-day window closing at the end of June, and we've seen a significant spike in the amount of funds that are trying to close taking advantage of this.

So we’re seeing a lot of Opportunity Zone ‘build-up’ coming to fruition now and we expect that to continue through June, with investment increasing through the second half of 2019 and 2020.

Preqin:  Do you see REITs being a bigger part of investor portfolios going forward?

REITs are a great investment in the current market which is evidenced by the uptick in REIT valuations that we’ve seen in 2019. Given some of the uncertainty and volatility seen in other markets, REITs have been able to provide a secure investment. For example, good economic growth, low unemployment and low interest rates have provided a really strong environment for real estate in the US. Investors that operate a diversified portfolio have likely shifted their allocation from industries that continue to be impacted by the ongoing trade war with China to the security of US real estate.

You might be sacrificing a little bit of return, but the volatility is significantly less.

How do you see real estate investment evolving in the US?

A trend we’re likely to see play out is the movement of activity from coastal areas of the US to the interior of the country.

Throughout most of the current cycle, the focus on US real estate has really been in coastal markets. But housing affordability in some of these areas is an issue, and given the high mobility of the millennial workforce, we’re likely to see some big plays in tertiary markets. Take Denver, Nashville and the Research Triangle in North Carolina: these areas are all seeing increased investment as investors look for exposure to these rising technology centres.

We’re also seeing the challenges surrounding US immigration drive activity in cities like Toronto. Toronto is thriving and quickly growing into a key market for real estate investment.

Preqin:  How important is ESG for real estate investors?

It’s certainly something that institutions look at and it will be the investor universe that will drive future growth in ESG investing.

At the asset level, we’re seeing most new projects that are going up incorporating ESG, and actually in some markets if you're not putting significant effort into renewable energy or reducing your carbon footprint, you're not getting the deal done in those geographies.

ESG investing in real estate actually ties in a lot with Opportunity Zones. As the Opportunity Zone program matures, we will see this regulation driving greater activity in terms of ESG investing in real estate. When you make ESG investments utilizing the Opportunity Zone program, the investment becomes not only a positive story but can provide a greater return than a more ‘vanilla’ ESG investment.

Take workforce housing investment. There is a huge market for the almost-forgotten middle class – our teachers, our firefighters, our police. Opportunity Zones will drive investment in workforce housing and because of the regulation, asset owners will see the positive story and investors will see the IRR.

- by Stu Taub and Troy Merkel
(reprinted with permission from rsmus.com)