By Steve LaTerra, Managing Director, Meyers Research
Join Steve LaTerra on Wednesday, June 28 at The Land & Capital Forum at 1:30-2:15 when he presents the "Annual Capital Markets Survey." He'll speak with Jeff Meyers and analyze the equity capital markets based on Meyers Research’s annual Capital Markets Survey, which explores capital's preferences in terms of geography, product type, deal structure and return requirement.
The real estate capital markets have become more structured and institutional over the last 30 years. This evolution was eloquently captured by former Morgan Stanley executive and real estate legend Buzz McCoy in his work, “The Dynamics of Real Estate Capital Markets” published by the Urban Land Institute in 2006. Buzz notes this structural shift has led to increasing fundraising volumes or allocations from established investment and hedge funds. Target portfolio allocations for real estate investment were pegged at 10% as the sector became viewed as an appropriate hedge against inflation and an accepted institutional asset class along with securities and bonds. Through 2016 and into 2017, real estate investment activity was robust but most capital sources were unable to reach their target allocations as political uncertainties and foreign competition challenged underwriters.
U.S. real estate continued to perform well in 2016 and the expectation is that there is more runway ahead in 2017. A recent survey of Senior Real Estate Executives by KPMG indicated that uncertainties over the tax policies, regulatory policies, the threat of rising interest rates, and issues surrounding cybersecurity have not dampened the bullishness of real estate owners and investors. According to the survey, 52% of real estate executives believe that improving real estate fundamentals in 2017 will be the biggest driver of their revenue growth and 91% of investors are bullish on access to equity capital.
This optimism is driven by the promise of reliable, although lower, returns in US real estate when compared to other global markets. This optimism has resulted in an increasing appetite for real estate in 2017. Demand for real estate is further driven by an influx of foreign capital seeking stability and, in some cases, escaping negative yields. The question is whether increasing appetites will lead to increasing volumes. Peak pricing, unsustainably low cap rates and the general lack of attractive deal flow has begun to impact real estate investment volume. The debt markets for commercial real estate have been slowing since 2016 driven by tightening regulations and burdensome retention rules. Without readily available debt, real estate volumes will likely fall. In fact, 2016 saw record levels of dry powder (uninvested capital) and distributions back to investors.
This is not to say that 2017 will be a weak year for real estate. To the contrary, we believe investment volume will continue at a robust pace and that the gateway coastal markets will be the largest targets for capital deployments. We expect to see the shift in asset class preference that began in 2016 will take hold in 2017. Notably, the appetite for ground-up Class A multi-family deals in non-gateway cities will drop significantly and will be replaced by emerging demand for office, industrial/fulfillment, warehouse, and various types of for-sale residential. We even expect increasing demand for niche real estate plays such as student housing, assisted living, medical office, single-family rentals and even select value-add retail opportunities. Lenders have been influential in the shift between real estate sectors as underwriting discipline has prevented much of the overbuilding that inspired cycle changes in the past. For most income producing real estate sectors, the risk of overbuilding based on established fundamental is low.
We assume 2017 will provide some clarity into the policies of the new presidential administration relating to taxation and regulation. We are carefully watching the proposed reforms of Dodd-Frank as well as potential tax changes associated with 1031 tax-deferred exchanges, carried interest provisions and pass through entities. How these changes ultimately affect investors will determine how real estate capital will be structured over the next four years. Perhaps more importantly for land development and homebuilding, some policy changes may incent investment into land and homebuilding, which has been sorely lacking for the last several years.
Check out the other articles in our 2017 Trends Series:
Meyers Research, a Kennedy Wilson Company, combines experienced real estate and technology advisors with leading data to provide our clients with a clear perspective and a strategic path forward. Based in Beverly Hills, we are home to 80 experts in 10 offices across the country.