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Real Estate Investment Quarterly Highlights
Second Quarter 2016
What’s Inside?
Real Estate Investment Quarterly Highlights features overviews of the following:
Real Estate Quarterly Highlights | Second Quarter 2016 2
U.S. commercial real estate cycle and recessions W NPI posted 6 consecutive calendar years of
double-digit total returns…Cycle is mature in a historical context
W Commercial real estate (CRE) total returns, capital flows, and price indices moderated in 1Q16
W NPI posted a 2.21% total return in 1Q16; the lowest quarterly total return since 1Q10
W CRE sales (RCA) declined by 20% in 1Q16 from a year earlier
W CRE prices (Moody’s/RCA CPPI) declined slightly in January and February, but had a modest uptick in March
W Some softening is not unexpected at this point in the cycle, especially with the transition to NOI-driven total returns
Sources: NBER; NCREIF, as of 1Q16; Real Capital Analytics; Moody’s Analytics, as of March 2016; US Board of Governors of the Federal Reserve System; TIAA.
NCREIF Property Index (NPI)1 total returns and U.S. recessions
1Q90–1Q16 W NBER recession W Total return (positive capital return) W Total return (negative capital return)
Pricing and probability of a downturn W NPI-derived initial yield is a gauge of CRE
pricing that is akin to a backward-looking cap rate
W NPI-derived initial yield spread, i.e., initial yield less the 10-year Treasury, is a gauge of relative value
W Initial yield spread increased in 1Q16 due to flat initial yield and declining Treasury
W With spread above its long-term historical average, current property pricing is still attractive with potential for further gains… Real estate is holding the line on relative value
W Initial yield spread can also act as a “canary in the coal mine” for U.S. CRE downturns; see gray-shaded areas
W Estimated probability of downturn in 4 quarters declined to 20%; a level still characterized as moderate risk…40% to 50% is worrisome
Real Estate Investment Quarterly Highlights
Real Estate Quarterly Highlights | Second Quarter 2016 3
Leading indicators
W Leading indicators suggest a continued positive foundation for property operational performance
W Good enough economic growth…Solid labor market… Low interest rates…Readily available commercial mortgage financing…Strong investor appetite…Generally well-balanced real estate fundamentals
W With all indicators in the “green” zone, conditions are supportive of solid NOI growth
W Primary concerns: Investor risk appetite, rising new construction, and unevenness in labor market recovery
Leading indicators of U.S. commercial real estate performance (2Q16)
Indicators Position Stall Overheat
Capi
tal
Mar
kets
Interest rates10-year Treasury yields remain below 2% amid sluggish global growth concerns; Lower-rates-for-longer continue to make real estate investment appealing
Investor risk appetiteWhen high-yield bond spreads shift up, cap rate spreads have tended to follow; Bond spreads increased materially since mid-’14, no cap rate spread impact yet
Deb
t Av
aila
bilit
y Debt for investorsCommercial real estate financing is readily available, no sign of credit bubble; Competitive environment with some lenders becoming more selective and aggressive
Debt for constructionConstruction lending supporting a growing supply pipeline that bears watching; Recourse loans and moderate loan-to-cost ratios prevail
Labo
r M
arke
t
Employment growthJob situation has recovered on a national basis, benefiting real estate demand; But, demographic and geographic employment recovery has been uneven
Unemployment rateToday’s unemployment rate above FOMC’s median estimate of 4.7% for 2016; Improvement in labor force participation rate, but only modest gains in wages
CRE
Fu
ndam
enta
ls Vacancy ratesEven with rising new construction, fundamentals generally remain balanced; Vacancy rates are expected to remain in proximity of long-term averages
Commercial property rentsRent growth trends are mixed across property types depending on new supply; APT have absorbed elevated deliveries, moderating rent growth expected
Source: TIAA, as of 2Q16.
Real Estate Investment Quarterly Highlights
Real Estate Quarterly Highlights | Second Quarter 2016 4
Leading indicators (cont.)
Capital markets W Capital markets drive commercial real estate
pricing through Treasury rates and risk spreads
W FOMC held interest rates steady at 0.25%–0.50% at its March and April meetings; any near-term increases are likely to be modest and gradual
W Yield on the 10-year Treasury remains low, ending the quarter below 2.0%
W U.S. high-yield (HY) bond spreads are strongly associated with U.S. real estate pricing
W When HY bond spreads shift up, cap rate spreads tend to follow
W HY spreads have increased materially since mid-2014, but cap rates haven’t been affected yet
Sources: US Board of Governors of the Federal Reserve System, Moody’s Analytics, as of 1Q16; BofA Merrill Lynch; Bloomberg, as of 1Q16; Federal Reserve Board, Flow of Funds, as of March 10, 2016; TIAA.
U.S. 10-Year Treasury yields and Fed funds target rates
1Q98–1Q16 W U.S. 10-Year Treasury yield W Fed funds target rate (midpoint)
1Q161Q141Q121Q101Q081Q061Q041Q021Q001Q980
1
2
3
4
5
6
7%
NPI1,3 transaction cap rate spreads and high-yield bond spreads
1Q98–1Q16 W NPI transaction cap rate spread W BAML B OAS
Real Estate Quarterly Highlights | Second Quarter 2016 5
Leading indicators (cont.)
Labor market W Employment growth drives the demand for
space and is a proxy for the macro economy
W Total employment has recovered…Average monthly job growth of 210,000 jobs over the past four years has been more than enough to absorb increases in the working-age population
W Recent employment reports have shown signs of modest wage gains
W Unemployment rate of 5.0% is above the FOMC’s 2016 median estimate of 4.7%
W Labor force participation rate has started to improve, but it remains well below its long-term average
W Geographic and demographic job recovery has been uneven
W Population cohorts based on educational attainment have had very different experiences in the labor market
68%Labor participation rate �nally beginning to improve
Sources: BLS, Moody’s Analytics, as of Apr 2016; BLS, Current Population Survey, Moody’s Analytics, as of 1Q16; NCREIF, as of 1Q16; TIAA.
Commercial real estate fundamentals W Commercial real estate market fundamentals
drive net operating income growth
W Current vacancy rates for each of the property types are at or below their long-term historical averages; APT and OFF are near their averages, IND and RET are well below their averages
W New construction pipeline requires monitoring…Pecking order of supply concerns from greatest to least among the four major property types goes from APT to OFF and IND to RET
U.S. real estate downturns and NPI1 vacancy rates by property type
1Q90–1Q16 W Negative capital return quarters W APT W OFF W IND W RET
Real Estate Quarterly Highlights | Second Quarter 2016 6
U.S. commercial real estate performance update W NPI has posted 22 consecutive quarters of
double-digit 4-quarter rolling total returns
W Positive 1-year total returns were recorded in all markets
W Average current value cap rate was 4.5% in 1Q16, roughly 36 basis points below its past low
W But, cap rate spread over 10-year Treasury remains slightly above its historical average, suggesting that real estate is holding the line on relative value
W Buyers are accepting historically low cap rates, but they are also receiving solid NOI growth
W NPI’s 4-quarter NOI growth rate increased to 6.7% in 1Q16 vs. 6.1% in 1Q15
W RCA reported a sizable drop in sales of commercial properties in 1Q16 as compared to 1Q15, largely attributable to fewer portfolio and large individual sales transactions
NPI1 rolling 4-quarter total, income, and capital returns
1Q90–1Q16 W Income return–ALL W Capital return–ALL W Total return–ALL
Real Estate Quarterly Highlights | Second Quarter 2016 7
Apartments (APT)Performance and pricing W APT’s 10.9% 1-year total return ranked third of
the four major property types in 1Q16
W Positive 1-year total returns were recorded in all APT markets
W Current value cap rate was 4.5% in 1Q16, roughly 24 basis points above its past low
W Current APT cap rate spread over 10-year Treasury remains well above its historical average, suggesting that APT sector still offers good relative value despite its low cap rate
W NPI–APT’s 4-quarter NOI growth rate was 9.5% in 1Q16, however, supply pipelines are still growing and expectations are for NOI growth to slow considerably
W RCA reported that the APT sector was the only property type to record a year-over-year sales increase in 1Q16; volume increased by 12% over 1Q15
Fundamentals outlook W Of the four major property types, APT sector
is likely the furthest along in the CRE cycle
W Most APT markets have absorbed recent deliveries without adversely impacting fundamentals
W Looking forward, APT sector faces the greatest concerns regarding new supply and expectations are for rent growth and vacancy improvements to moderate
W Forecast completions, as of 1Q16, are expected to exceed historical completions in 27 of 50 markets
W Forecast vacancy rates, as of 1Q16, are expected to exceed historical vacancy rates in 27 of 50 markets
NPI1 rolling 4-quarter total, income, and capital returns
1Q90–1Q16 W Income return–APT W Capital return–APT W Total return–APT
Historical and forecast completions for 50 largest APT markets4
1996–2020
APT
aver
age
fore
cast
com
plet
ions
(% o
f sto
ck, 2
016–
2020
)
APT average historical completions (% of stock, 1996–2015)
Forecast > Historical
Forecast < Historical0
2
3
4
1
5%
0% 1 432 5
Historical and forecast vacancy rates for 50 largest APT markets4
1996–2020
APT
aver
age
fore
cast
vac
ancy
rate
(201
6–20
20)
APT average historical vacancy rate (1996–2015)
Forecast > Historical
Forecast < Historical2
6
8
4
10%
2% 4 1086
Sources: NCREIF, as of 1Q16; CBRE-EA, as of 1Q16; TIAA.
Real Estate Investment Quarterly Highlights
Real Estate Quarterly Highlights | Second Quarter 2016 8
Industrial (IND)Performance and pricing W With a 14.3% total return, IND was the best
performing sector
W Positive 1-year total returns were recorded in all markets
W Average current value cap rate was 5.0% in 1Q16, roughly 60 basis points below its past low
W But, current IND cap rate spread over 10-year Treasury remains slightly above its historical average, suggesting that the IND sector offers fair relative pricing
W NPI–IND’s 4-quarter NOI growth rate has followed a general pattern of acceleration throughout the recovery, reaching 8.2% in 1Q16
W According to RCA, sales of IND properties declined 38% in 1Q16 from the same period last year, but still remain strong on a historical basis
Fundamentals outlook W IND markets have benefitted from healthy
consumer spending and growth in imports which drive space demand
W Construction has increased in response to historically low availability rates in some markets
W Forecast completions, as of 1Q16, are expected to exceed historical completions in 7 of 50 markets
W Forecast availability rates, as of 1Q16, are expected to exceed historical availability rates in 24 of 50 markets; in these instances, most market forecasts are only slightly above historical averages
NPI1 rolling 4-quarter total, income, and capital returns
1Q90–1Q16 W Income return–IND W Capital return–IND W Total return–IND
Historical and forecast completions for 50 largest OFF markets4
1996–2020
OFF
ave
rage
fore
cast
com
plet
ions
(% o
f sto
ck, 2
016–
2020
)
OFF average historical completions (% of stock, 1996–2015)
Forecast > Historical
Forecast < Historical0
2
3
4
5
6
1
7%
0% 1 5432 6 7
Historical and forecast vacancy rates for 50 largest OFF markets4
1996–2020
OFF
ave
rage
fore
cast
vac
ancy
rate
(201
6–20
20)
OFF average historical vacancy rate (1996–2015)
Forecast > Historical
Forecast < Historical6
16
18
20
10
12
14
8
22%
6% 10 12 148 16 18 20 22
Sources: NCREIF, as of 1Q16; CBRE-EA, as of 1Q16; TIAA.
Real Estate Investment Quarterly Highlights
Real Estate Quarterly Highlights | Second Quarter 2016 10
Retail (RET)Performance and pricing W RET was the second highest performing sector
of the four major property types
W Positive 1-year total returns were recorded in all but one market, St. Louis, MO (-0.9%)
W Average current value cap rate was 4.7% in 1Q16, almost 90 basis points below its past low
W But, current RET cap rate spread over 10-year Treasury remains well above its historical average, suggesting that RET sector still offers good relative value
W NPI–RET’s 4-quarter NOI growth rate has held fairly steady as of late; as of 1Q16, it was 3.8%
W According to RCA, sales of RET properties decreased during 1Q16; transaction volume declined 31% from 1Q15
Fundamentals outlook W Retail sales growth was modest to begin the
year; sales excluding motor vehicles and parts increased 2.3% in 1Q16 compared to 1Q15
W Benefits from lower gas prices, a strong job market, and improved credit availability should support stronger retail sales growth and more meaningful improvements in availability rates
W Looking forward, RET sector faces the fewest concerns regarding new supply
W Forecast completions, as of 1Q16, are not expected to exceed historical completions in any of the 50 examined markets
W Forecast availability rates, as of 1Q16, are expected to exceed historical availability rates in 32 of 50 markets
NPI1 rolling 4-quarter total, income, and capital returns
1Q90–1Q16 W Income return–RET W Capital return–RET W Total return–RET
Historical and forecast completions for 50 largest RET markets4
1996–2020
RET
aver
age
fore
cast
com
plet
ions
(% o
f sto
ck, 2
016–
2020
)
RET average historical completions (% of stock, 1996–2015)
Forecast > Historical
Forecast < Historical0
2
3
4
1
5%
0% 1 432 5
Historical and forecast availability rates for 50 largest RET markets4
1996–2020
RET
aver
age
fore
cast
avai
labi
lity
rate
(201
6–20
20)
RET average historical availability rate (1996–2015)
Forecast > Historical
Forecast < Historical3
11
13
15
9
7
5
17%
3% 75 9 11 171513
Sources: NCREIF, as of 1Q16; CBRE-EA, as of 1Q16; TIAA.
Real Estate Investment Quarterly Highlights
Real Estate Quarterly Highlights | Second Quarter 2016 11
U.S. commercial real estate prospectsMarket volatility + mature real estate cycle = anxious times
W Some softening is not unexpected at this point in the cycle, especially with the transition to NOI-driven total returns
W No indications of an imminent downturn…Our model indicates moderate risk of a real estate downturn
W Volatility indicates heightened sensitivity to macro-economic and financial market shocks
W U.S. real estate markets are generally well-balanced…Shock would likely be well-tolerated were it to hit
Our “house view” regarding real estate performance has not changed…
W Total returns are facing constraints…Not all components of total return likely to be material contributors
W Low yields, limited potential for further cap rate compression, and capital expenditure drag
W NOI growth is expected to be the driver of total returns going forward
W New construction is anticipated to be a key determinant of NOI growth performance
No clear “buy”, “sell”, or “hold” recommendations…view depends on investor’s perspective, risk appetite, and time horizon
W Buyers will focus on solid economic growth prospects, balanced fundamentals, and attractive spreads
W Sellers will focus on low absolute cap rates, appreciation to date, and opportunity to exit
W Holders will focus on uncertainty and do nothing
W Longer horizons can better tolerate today’s volatility…Shorter horizons may need more defensive actions
W Defensive actions can include investment strategies and market focus
1. It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs.
2. Probabilities are for the quarter indicated and are calculated using data from 4 quarters prior.
3. Cap rate spreads are the difference between NPI transaction cap rates and 10-year Treasury yields. High-yield bond spreads are represented by the BofA Merrill Lynch B OAS.
4. Largest 50 markets are determined by ranking markets according to existing stock. Data for 1996 through 2015 are actuals; data for 2016 to 2020 are forecasts.
Real Estate Investment Quarterly Highlights: Second Quarter 2016 is prepared by TIAA Global Asset Management and represents the views of TIAA Global Real Estate Group as of March 2016. These views may change in response to changing economic and market conditions. Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Data is as of 3/31/2016 unless noted otherwise.
Real estate investing risks include fluctuations in property values, higher expenses or lower income than expected, higher interest rates which affect leveraged investments, and potential environmental problems and liability. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, are not deposits, are not insured by any federal government agency, are not a condition to any banking service or activity, and may lose value.
TIAA Global Asset Management provides investment advice and portfolio management services through TIAA and over a dozen affiliated registered investment advisers.