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2018 Real Estate Outlook: Real Estate Cycle Maturing; M&A Picking Up

After several years of strong growth, we believe the real estate cycle is set to mature in 2018.

As supply concerns emerge in certain key markets, average rent growth is likely to moderate, while slowly rising interest rates may put pressure on debt financing. However, we also believe pockets of growth remain in select markets and sectors. In addition, merger and acquisition (M&A) activity is increasing in certain commercial real estate sectors, offering another source of potential growth.

In our view, the real estate market remains healthy. Rent growth is positive and occupancy rates are close to all-time highs. However, towards the end of 2017, rent growth began to slow in certain markets and sectors. In particular, office and apartment rent growth slowed in gateway cities like New York City and Washington D.C. Looking ahead to 2018, we are likely to see continuing weakness in these and other gateway coastal markets, especially given their relatively high new supply.

However, growth potential may still be found in real estate markets in so-called Sun Belt states such as Florida, Arizona, Texas, and Georgia. These low-tax states typically have seen strong employment growth in recent years. This has attracted new residents and created strong demand for housing, retail outlets, healthcare centers, and office and warehouse space. At the same time, new supply in these markets has been constrained as the cost of new construction far exceeds the cost of acquiring existing properties.

The Sun Belt states have historically had significantly lower property prices than the coastal states and have charged lower rents. Therefore, there is more room for rent increases in these markets than in oversupplied and expensive coastal markets, as well as the potential for higher cap rates. Thus, market selection will be an important source of growth in 2018.

Another potential source of growth is rising M&A activity. By the end of 2017, most regional mall real estate investment trusts (REITs) were trading at significant discounts to net asset value (NAV). In some cases, the discount was as high as 50 percent. Even given the relatively weak performance of the retail real estate sector, these discounts are attractive and opportunistic investors are taking note. There was an uptick in M&A activity in the retail REIT sector towards the end of 2017, and this will continue into 2018.

Consolidation in the retail REIT sector may offer a potential opportunity for investors. REITs that acquire new assets at a steep discount to NAV have the potential to deliver positive returns for investors as the retail environment recalibrates and stabilizes.

Looking ahead, we may also see an increase in M&A in other real estate sectors. Office REITs, for example, are trading at 15 to 25 percent discounts to NAV, which may make the office sector a candidate for consolidation activity in the next 12 to 18 months.

In terms of 2018’s downside risks, one area of potential concern is the commercial mortgage-backed
securities (CMBS) market.

The 2015-to-2017 period saw a spike in CMBS maturities on paper dating back to the peak of the previous cycle, between 2005 and 2007. This created various investment opportunities as issuers refinanced.

We are likely to see fewer maturities in 2018 because CMBS originations dried up in 2008 in the wake of the financial crisis. Nevertheless, up to $100 billion in CMBS will need to be refinanced in the coming year and CMBS originations remain healthy.

Against the backdrop of slowly rising interest rates and a narrowing yield curve, however, refinancing may prove more expensive than it has in recent years. Some issuers may struggle to refinance, which may lead to a degree of market disruption. This is a potential headwind for commercial REITs.

Overall, 2018 has the potential to be a complex year for real estate investors. As gateway markets slow and the cycle matures, finding growth may require actively seeking out suitable markets and sectors. We believe active management has the potential to perform well in such an environment.

This information is educational in nature and does not constitute a financial promotion, investment advice, or an inducement or incitement to participate in any product, offering or investment. It is not intended to be used as a tool to determine your specific financial situation, tax status, investment objectives, investment experience, suitability for any specific investment, risk tolerance or investment profile. Resource is not adopting, making a recommendation for or endorsing any investment strategy or particular security. The materials included herein are the property of Resource and may not be repurposed in a separate likeness without the express written consent of Resource.

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