Summary of 2019 & Profimex’s 2020 Outlook
As we enter the New Year, we would like to wish you a happy new year.
The New Year is an excellent opportunity to look back on a successful 2019 and present our forecast for 2020. Much like 2019, we expect 2020 to continue to be characterized by the moderation of high yields and continued growth despite uncertainty in the market cycle. This type of economic environment further emphasizes the need for experienced and professional investment managers.
In 2020, Where Are We In The Economic Cycle?
Economies are constantly in motion, regularly fluctuating between cycles of growth and contraction. Precisely identifying the stage within a cycle – or its duration – is only fully possible in retrospect. Despite this challenge, much research and debate has been expended into the question of: what is the current status of the global economy? Today, in particular, this question is significant, as the economy seems to be edging towards the end of the current market cycle.
The current market cycle is characterized by a wealth of investment opportunities, low interest rates, and appreciation in values. These characteristics have allowed for investors to realize phenomenal returns on their investments. Despite the timing in the cycle, financial forecasts remain encouraging for the future, predicting continued positive growth (although not at the same pace of the last decade), continued low interest rates, and stable market fundamentals continuing to fuel the economy.
Real estate rental rates, in particular, are expected to continue to increase in the markets that we examined – specifically, in North America and Asia Pacific. In the UK, however, uncertainty surrounding Brexit continues to make it difficult to predict market performance.
In this economic environment characterized by uncertainty in the market cycle, high prices, and reduced yields – there are still good investment opportunities; however, it is more challenging to find these opportunities and you must be more cautious with decisions and work only with experienced managers.
U.S. Real Estate Market
As of June 2019, the U.S. has experienced its longest period of economic growth, surpassing its previous peak of 120 months from March 1991 to March 2001. According to forecasts, the U.S. economy is expected to continue to grow, with projected GDP growth of 2.3% in 2019 and 2.0% in 2020. Naturally, some states demonstrate more favorable growth than others.
The U.S. labor market has also seen an increase in 2019, with an estimated 2 million new jobs created, alongside a moderate increase in wage growth. The U.S. unemployment rate in 2019 has dropped to 3.5% as compared to 3.9% in 2018 and is the lowest in the last three decades.
The average rental growth across all sectors of real estate has increased by 3.3% in 2019.
Interestingly, although the number of new households has been increasing since early 2012, growth in homeownership has dropped from its peak of 69.2% in 2004 to 64.8% in the third quarter of 2019. This represents a continued trend of renting, which appears preferred to home-ownership in the U.S., and should continue to fuel consistent demand for multifamily rental units for the foreseeable future.
This sector has provided the highest long-term, risk-adjusted returns, as well as the least volatility in annual returns over the past 30 years. It continues to benefit from favorable demographic trends, which include a rental base of 80 million millennials (23 to 38 years old), 65% of whom currently rent (despite a recent increase in homeownership) according to the latest U.S. Census Bureau survey. Additionally, there is a growing rental base of baby boomers (76 million people aged between 51 and 69), who are expected to downsize and transition from homeowners to renters over the next two decades, further increasing the demand for rental units, despite the increased supply of houses that will reach the market as boomers sell their homes.
National average rental rates increased 34.7% between 2011 and 2018. Despite the tremendous increase in multifamily properties, cap rates remain competitive in all major markets due to continued investor demand. The cap-rate-spread between class-A and class-B assets, as well as between primary and secondary markets, remains tight and indicates that many investors may be looking towards investment opportunities in lower-quality assets and secondary or tertiary markets, which tends to offer more value-add opportunity. The most meaningful decrease in cap rates were for class C assets and for secondary and tertiary markets.
Retail & Logistics
According to CBRE, retail rent has continuously decreased by 3% across the U.S., as traditional, big-box shopping centers and one-size-fits-all retailers are going out of business. Although many online retailers have been seeking to establish a brick-and-mortar presence, their aim is to craft an experience that showcases their logo or story, rather than a spatially large footprint to sell merchandise.
Retail spaces that are experiential or entertainment related; centering around food and beverage, amusement, fitness, and one-of-a-kind activities, continue to push the boundaries of what a retail center is. Shopping malls anchored by regional grocery stores and gyms remain the gold standard.
This sector has seen 30% growth over the last five years and has been fueled by the overwhelming growth of e-commerce. Despite high prices and more moderate yields, forecasts indicate a trend of continued rent growth and increased value. The most attractive logistics assets are in the outskirts of cities. These strategic locations and distribution points support broad-scale distribution capabilities as well as 1-day delivery services.
Despite a decade of technological developments that enables working remotely, the office sector continues to adapt and the outlook in 2020 and beyond remains optimistic with conservative growth prospects.
Economists believe the fundamentals are in place for a similar performance to that of 2019. This performance was defined by steady rental growth (2.7%), stable vacancy (16.8%), low interest rates, absorptions in line with completions, and nominal cap rate compression. High-growth tech, creative, and life-science tenants will continue to drive strong occupancy and absorption in new class-A supply with a preference for primary markets. While location remains a key factor, workspace opportunities remain strong in both primary and secondary markets.
The contemporary office is best described as a flexible office space that accommodates multiple working styles and approaches. The failed WeWork IPO has worried many investors regarding the prospect of growth in this particular sub-sector of flexible workspace (which currently accounts for less than 2% of the office market). We believe that co-working or flexible office space still holds great potential, specifically, as an added component to the traditional office strategy. Many property owners have successfully implemented a strategy utilizing a portion of their office building as a flexible office space.
According to CBRE’s Q3 global rent and capital value indices published in November 2019, both office and industrial sectors reported an average annual growth of 3% across the U.S.
In Europe overall investor perception for 2020 remains positive, with strong market indicators offsetting economic slowdown and geopolitical challenges.
The likelihood of a hard Brexit continues to affect UK markets, creating uncertainty as evidenced in both the lowest volume of office transactions since 2010 and a decrease in London housing prices. Nonetheless, the UK economy signals resilience: occupier demand continues, unemployment rates remains static below 4%, and global money continues to flow to assets in the UK, accounting for approximately 50% of 2019 real estate transactions. In fact, the weakening pound attracted investors in the second half of 2019 and may offer foreign investors further opportunities in 2020.
Similarly, in the rest of the Eurozone, with interest rates at virtually 0% and unlikely to rise in the foreseeable future, global liquidity is driving demand for real estate in Europe. While the German manufacturing sector is experiencing a decline, this has not yet affected real estate markets. The main question for investors remains whether the industrial downturn will flow over to other sectors of the economy.
In the short term, the Eurozone’s robust services sector continues to offset the manufacturing falloff. The labor market is healthy, employment is at a record high, and wages are rising. Strong occupier demand with limited availability of quality assets, coupled with favorable monetary policies and low borrowing costs, may further increase asset prices in higher yielding markets. In addition, prime asset prices in most mature markets are expected to stabilize.
With record low yields and a lack of supply of prime office properties, investors remain focused on quality of income and rental growth and are moving into secondary locations.
The burgeoning logistics sector across Central and Eastern Europe continues to attract investor interest. Undersupply and occupier demands are expected to further compress yields and increase prices. Poland, the fastest growing logistics market in Europe, with strong economic fundamentals, better infrastructure, and lower labor costs, will be a market to watch.
In retail, landlords continue to witness the effects of e-commerce. As tenant turnover stabilizes, micro-locations and tenant mix will determine this sector’s success.
As for residential properties, investors are increasingly cautious, due to regulatory measures to freeze rent escalations and impose a cap on rents in certain European cities, notably in Germany. For example, a law imposing a rental freeze in Berlin is set to go into effect in 2020. Despite this, the actual impact of these regulatory initiatives remains questionable, since apartment prices in Berlin have increased 12% year over year.
Summary & Final Thoughts
Real estate prices in many areas have already exceeded the prices of the pre-crisis period of 2008. Driving these record high prices is the demand for quality real estate and the considerable amount of capital available for investment. This force is particularly strong on larger transactions, as a result of the amount of commitments and dry powder available within certain mega-funds and with some of the world’s largest institutional investors. Their focus has and will continue to be on large-cap investments and portfolios.
In contrast, we at Profimex, together with our partners, will continue to source reasonably priced investment opportunities in properties that have not as of yet been affected by demand-driven price inflation. We will achieve this by focusing on the size of the investment, the location of the investment, and the investment market, as well as by utilizing our strategic partners’ experience and knowledge of the particular market. We believe that investors like us, who are not pressured to invest large amounts per transaction, will continue to benefit from a healthy real estate market that is backed by a steady growing economy and strong economic fundamentals. We plan to continue to focus on investments that have been analyzed and that promise a rate of return that matches the level of risk.
In 2019, we invested in a total of only 19 investments, after thousands of potential investments were evaluated through a comprehensive screening process unique to Profimex and its strategic partners. This fact, along with our rich experience, will protect our investors’ interests by providing downside protection and maximizing their returns.
As ever, we shall continue to serve you with integrity and transparency. Many of you have been investing with Profimex for many years and are secure in the knowledge that our business is a respectable one that always has your best interests at heart. We thank you for your trust across two decades.
With best wishes for the New Year
The Profimex Team