Viewpoint: Sovereign Wealth Funds Among Major Stories for REITs

3/3/2016

By
Greg Steele

The prospects for REITs in 2016 are encouraging, with sovereign wealth funds continuing to invest aggressively in U.S. markets and the Fed's policy of incremental interest rate hikes signaling confidence in the U.S. economy as a whole. Although the precipitous decline in oil prices has created headwinds in Houston, especially for multifamily and office sectors, even here, job growth remains positive. In the meantime, REITs are reconfiguring their portfolios to focus on new uses of space in the industrial and office sectors in response to new business models and advances in technology.

Here's a snapshot of how the market is shaping up for 2016.

Sovereign wealth funds (SWFs) will remain active investors in U.S. real estate in 2016, and U.S. REITs are poised to benefit from this trend.

SWFs view U.S. real estate as an attractive investment class with a desirable combination of current return, long-term appreciation potential and inflation protection. SWFs seek to acquire best-in-class assets in major urban markets, often in JVs with experienced, well-capitalized U.S.-based partners. While SWFs in oil-producing countries may slow their investment pace due to lower oil prices, Asian and European investors will continue to invest aggressively.

The strength of the U.S. dollar is also seen as a positive by many offshore investors seeking to preserve long-term value. Recent easing of the FIRPTA tax rules will also facilitate SWF investment.

REITs are well positioned to benefit from these trends as they are among the largest, most experienced, and best capitalized owners of real estate in the U.S.

Technological changes and tenants’ demand for more flexible office space will put pressure on traditional office landlords; office REITs have the scale, urban footprint and property management expertise to benefit from this trend.

While demand for office space in gateway cities remains strong, the urban office segment is seeing a gradual shift away from traditional lease structures toward collaborative and shared-use locations and greater flexibility in space utilization. Office leases will reflect that increased flexibility, allowing tenants to scale their space needs up or down according to their needs.

For example, WeWork, a provider of shared workspaces, leases large office spaces and sub-leases them on demand to entrepreneurial businesses, and is working with Vornado Realty Trust (NYSE: VNO), a large office REIT, to redevelop office space in Washington.

We expect the trend toward flexible leases will accelerate as more companies adopt this business model in future. These emerging companies also favor urban, amenity-rich office buildings near major transportation nodes, where REITs are increasingly focusing their investment and development activity.

The Industrial REIT sector will be a bright spot in 2016 as trends point to continued rent growth, fueled by the growth of e-commerce and fundamental changes in retailers’ business models.

The growth of e-commerce remains a major tailwind for the industrial REIT sector, and we’re seeing fundamental changes in retailers’ business models that emphasize online purchases and same-day delivery, trends that benefit industrial properties supporting “last-mile” delivery. Industrial REIT managements have been aggressively cycling out of older generic properties in anticipation of the growth in e-commerce.

Higher interest rates may be a net positive for REITs, especially since the pace of Fed rate hikes is expected to be incremental. Bond investors will continue to strongly support the REIT sector, especially experienced issuers.

The Federal Reserve’s rate hike signals its confidence in the underlying health of our labor markets and the outlook for economic growth and job creation. Job growth is a major factor driving improved leasing market dynamics; as space is absorbed, rents rise. Historically, a rising Fed Funds rate has coincided with tightening commercial real estate markets and rising prices, as we’ve seen in the previous two tightening cycles (1993 to 2000 and 2003 to 2007).

The Fed has also clearly signaled a very gradual pace of tightening, which bodes well for the length of the current economic cycle and the likelihood of healthy CRE markets in 2016 and beyond. The Fed’s deliberate approach is likely to keep long-term rates muted, which is also a positive for long-term debt markets.

Experienced REIT bond issuers will continue to have strong access to bond markets even if conditions are choppy; inaugural issuers will need to be patient and look for calmer markets.

REITs with meaningful Houston exposure will experience valuation headwinds in 2016 as sharply lower oil prices work their way through the local economy. Office and multifamily sectors are showing signs of stress, but retail remains healthy.

Institutional investors are taking a cautious view of Houston as lower oil prices affect REITs that own properties there.

Different sectors will be affected in different ways. Multifamily is coming under pressure in Houston with modestly declining occupancy, high levels of new supply and pressure on rents. The Houston office sector is seeing similar pressure with high levels of available sublease space and pressure on occupancy rates.

The market still offers bright spots: Houston’s retail sector remains healthy, with sales up 4 percent in 2015, and overall employment growth in Houston is still expected to be modestly positive in 2016. However, while Houston commercial real estate markets are under stress, REITs with Houston exposure, especially in the retail sector, may be oversold as investors seek to reduce exposure to that market.

Greg Steele is managing director of REIT investment banking at Capital One.

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