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Research Insights, December 15, 2015

Tighten Those Seatbelts In 2016 Fortune Will Favor the Balanced Over the Bold

While 2015 was not as advertised, it was largely as we expected.  As late as December 2014, a Wall Street Journal survey of economists projected the 10 year Treasury rate to end the year at 3.2%,  100 basis points above the actual year-end rate.  This was based on expectations of accelerating economic growth, rising inflation, and resultant Fed rate hikes – none of which occurred.  Instead, 2015 started out with an economic whimper as first quarter GDP contracted 0.2%, in stark contrast to the same WSJ forecast of a 2.8% advance.  Inflation declined in two of the first three months of the year on a year-over-year basis, putting the previously expected mid-2015 Fed rate hike on hold. 

As we predicted in our spring research newsletter, “Spring Transition Brings Stormy Weather”, there was significant financial market volatility.  Daily price movements in Treasuries spiked to 2.5% in June, the highest level for a spring period since 2009 and the equivalent of an average daily price move of 450 points in the DJIA. Financial market volatility then transitioned from the bond market to both domestic and global equities.  Intraday price movements in the DJIA more than doubled from 178 for the first eight months of the year to 354 for the period from August – September, while Chinese equity markets increasingly resembled a rollercoaster.  Collectively, this resulted in Treasury rates ending the summer four basis points below the previous December as investors continued to seek safe haven assets.  

In spite of a year-end spike in equity market volatility driven by increasing concerns surrounding high-yield debt, the Federal Reserve raised the discount rate target 25 basis points in December.  This was a welcome relief to those who saw this as a signal of the Fed’s belief that the U.S. economy was able to withstand a rate hike in spite of events at home and abroad.  The actual calculus likely signals less the Fed’s positive outlook on the U.S. economy and more its weighing the risks of increasing rates in the face of weakening global economic growth against the need to “reload” its monetary bullets before the next recession

Real Estate Performance

During the course of 2015, commercial real estate returns continued to defy consensus return expectations.  Conventional wisdom at the beginning of the year was for more normalized long-term returns in expectation of moderating appreciation rates due to an anticipated increase in interest rates and the resulting upward pressure on cap rates.  However, much as we anticipated, interest rates largely remained flat and inflation non-threatening.  As financial market volatility increased, returns were in line with our projections as commercial real estate once again experienced strong rates of appreciation, mirroring investors’ continued flight to asset classes offering favorable income yields and relative stability.

In our November 2014 newsletter, we predicted that during the course of 2015 investors would succumb to the siren song of smaller markets offering higher initial yields, in sharp contrast to our disciplined approach of focusing on markets offering a combination of superior long-term income growth prospects and pricing resiliency subsequent to a downturn.  This largely turned out to be the case during the year, and, as economic weakness played out in the latter half of 2015, those investors are now becoming increasingly concerned about pricing levels and future performance, while our approach already has us well-positioned for 2016.

Property fundamentals1 were increasingly strong across all property sectors, with multi-family and industrial assets surprising most – including us – to the upside.  Unexpectedly robust demand combined with limited supply created stronger than anticipated gains in occupancy and rents.  Year-to-date (through third quarter of 2015) multi-family net absorption is 187,000 units, more than double the 2005-2007 average of 89,000 units, and the vacancy rate stands at 3.7%, well below the 2005-2007 average of 5.8%, all leading to higher year-over-year rent growth.  Industrial net absorption is a robust 112M SF, yet supply year-to-date remains in line with the 2005-2007 average. 

As a result, the 8.1% industrial vacancy rate is well below the 2005-2007 level, leading to robust year-to-date rental growth rate in the sector. 

Office demand, although less robust than in the previous cycle, combined with exceptionally limited supply to produce strong rent growth in the sector for 2015.  Year-to-date office net absorption is 68M SF, healthy but down from the 2005-2007 average of 90M SF, and supply remains muted compared to prior recoveries.  As a result, rent growth year-to-date has been strong at 4.3%, mirroring the 2005-2007 average. 

Lastly, retail, also benefitting from limited supply, remains in the earlier stages of its recovery and, we believe, has yet to realize its rent gain potential. 2015 retail net absorption was 54M square feet, down significantly from the 2005-2007 average of 132M SF as was supply, leaving the national retail vacancy rate at 5.9% with year-over-year rent growth of 2.7% versus the 2005-2007 average of 4.3%.   

2015 was another Goldilocks years for commercial real estate.  Continued low yields, just enough financial market volatility to drive increasing capital flows to the relative stability of the asset class, and strong property fundamentals creating a favorable environment for commercial real estate returns.

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