With the results of the 2016 US presidential election behind us, there is at least one certainty—who the president of the US will be in 2017. Beyond that fact, not much else is certain. The new administration’s policies are yet to be prioritized and publicized, and as such, it is unclear what the impact of the new administration will be on the US economy or if there will be any impact altogether from the transfer of executive power. The uncertain political climate adds to what is an already murky mix of economic indicators. Quarterly GDP growth, employment and wage growth, corporate sales and profits, financing activity and a multitude of other signals providing insight into the direction of the US economy have been vacillating of late, causing confusion as to whether the US economy will get a kick-start and continue along a more robust growth trajectory or stall out and reverse course.
Although the future direction of the US economy has become less clear, the consensus seems to be that the country is on solid footing for the time being. Indicators of economic strength, such as GDP growth, employment levels, consumer confidence, manufacturing activity and trade activity have all shown resiliency over the course of the year. In short, no major ‘red flags’ have gone up yet signaling any sort of distress in the US economy, and as such, the country remains an investment safe haven relative to other global markets, with investment capital continuing to pour into the country. Foreign investors seeking Islamic finance products in the US continued to show the greatest interest in private real estate investments in 2016, with relatively marginal activity on US originated Sukuk issuances or other sectors of Islamic finance. US real estate valuations have been bolstered by strong fundamentals and a high level of interest from a multitude of capital sources in 2016. Apart from the fact that US real estate fits well with requirements of Islamic financial products, the current strength and stability of the asset class make it the center of focus for Islamic financial transactions in the US.
Review of 2016
With 2015 having been an exceptional year for investment activity in the US real estate sector, it is no surprise that investment volume in 2016 has declined from the prior year. It is important to keep this decline in perspective, however. 2015 marked the sixth straight year of increasing investment activity in US real estate reaching nearly US$550 billion-worth of transaction activity by some estimates. To surpass or even meet 2015’s total investment volume would have been difficult. Final investment sales figures for 2016 will not be published until well into 2017; however, all indications are that the 2016 total volume will be down slightly from the prior year.
In spite of the decline in transaction volume, property valuations have remained stable. In fact, some sources suggest that weighted average cap rates have actually continued to decline over the course of 2016, tightening by as much as 35bps from the third quarter of 2015 to the third quarter of 2016. Fundamentals for the sector also remained strong in 2016 as growth in property level net operating income continued to outpace price inflation in the wider economy. Operating income growth from individual properties in 2016 was not as strong as 2015, but again, it is important to keep in perspective that 2015 was a record year for US real estate with some property classes such as apartments and hotels reportedly seeing as much as a 6-8% average growth in operating income across the sector.
Encouraged by the healthy level of investment activity and growing income trends in the sector, foreign investors continued to play a major role in US real estate transactions in 2016. Over the past few years, foreign investors have been net buyers of US real estate even in periods when domestic institutions, REITs and private domestic investors have been net sellers. In 2016, however, foreign capital sources faced stiffer competition for US properties. While REITs remained net sellers, domestic institutional investors and private buyers joined foreign investors as net buyers in the marketplace. In spite of peak pricing, these capital sources made a grab for US real estate in 2016 as they had few choices for yield-generating assets in what has become a virtually negative yielding fixed income environment around the globe.
Preview of 2017
As mentioned previously, ‘red flags’ have yet to be identified that would signal a retreat in the strong fundamentals that underpin peak valuations of US real estate at present. If occupancy levels remain at or even decline slightly from their current levels and rents continue to grow or even stabilize without significant decline, property valuations are unlikely to deteriorate in the near term. Supply and demand dynamics are also favorable as we look forward to 2017. The pace of new construction has been muted in the current cycle relative to previous cycles, allowing for steady absorption of new products and limited backlog. Even with the robust availability of capital from both domestic and foreign sources in the form of both debt and equity, new construction remains in check. The current balance of strong fundamentals, plentiful liquidity and a favorable supply/demand dynamic portends another healthy year for US commercial real estate valuations and investment activity in 2017.
The wild card affecting valuations and transaction activity, however, will be the pace at which interest rates begin to rise. Credit markets have seemed to price in an increase in US interest rates before the end of the year. The rise in interest rates is imminent, but the pace of that rise is unknown. Nonetheless, the yield generation potential of US real estate appears to be comparatively attractive even in a rising interest rate environment. Average cap rates are still somewhere between 350-400bps higher than 10-year US government treasuries. That spread will need to contract by at least another 100bps before inflation alone begins to threaten the relative attractiveness of US real estate among yield-oriented investors.
Conclusion
As we transition from 2016 to 2017, it seems that the collective consciousness of investors in US real estate has also begun to transition from a sentiment of pure optimism to one of cautious optimism. The positive trajectory of the US real estate market has been slow and steady and sustained over several years following the Great Recession. While there are no apparent signals that the recovery should or will reverse course over the next 12 months, the mere fact that the recovery has sustained for this long naturally gives rise to caution. Caution, however, is distinct from pessimism and in fact, it is often caution that allows for continued growth in cycles that would otherwise come to a crashing halt when optimism remains unchecked. Real estate has been the backbone of Islamic financial activity thus far in the US and should continue to provide a strong foundation for Islamic investments in the US for the foreseeable future.
Anup Patel is the president and chief investment officer of Arch Street Capital Advisors. He can be contacted at [email protected].