THE LURE OF ALTERNATIVES ENTICES INVESTORS
Specialty sectors including self-storage, data centers, medical office, life sciences facilities, seniors housing and student housing have been particularly enticing to commercial real estate investors over the past six years. The same holds true for the year ahead.
Broad interest in alternatives is noted in CBRE’s 2019 InvestorIntentions Survey, which found that 40% of survey respondents were actively pursuing one or more alternative sectors. Higher yields are one principal attraction of alternatives. Generally healthy market fundamentals and impressive long-term growth potential due to secular shifts in demand are also drawing capital to specialty sectors.
ALTERNATIVES INVESTMENT VOLUME ON THE RISE
Investment in the major specialty sectors has risen steadily in both volume and market share over the past decade. Volume more than doubled in 2011 and again in 2014. Since 2014, alternatives investment volume has averaged $59 billion annually, accounting for 12% of all commercial real estate investment. At the peak of the last cycle (2007), alternatives investment was half this amount and only 6% of total commercial real estate investment. Preliminary data for 2019 shows that alternatives’ market share rose to nearly 13% of total commercial real estate investment.
FIGURE 14: ALTERNATIVES INVESTMENT MARKET SHARE, 2007 VS. 2019 YTD
Source: CBRE Research, Real Capital Analytics, Q3 2019. *2019 is estimated based on data year-to-date through August.
FIGURE 15: HISTORICAL INVESTMENT OF ALTERNATIVE REAL ESTATE SECTORS
Source: CBRE Research, Real Capital Analytics, Q3 2019. Year-to-date through August.
FIGURE 16: ALTERNATIVES INVESTMENT, 2014-2019 YTD ANNUAL AVERAGE
Note: Percentages represent market share of all alternatives investment.
Source: CBRE Research, Real Capital Analytics, Q3 2019. *2019 is based on data year-to-date through August.
FIVE FACTORS THAT ATTRACT INVESTORS TO ALTERNATIVES
The increased interest and buying activity in alternatives have been driven by five primary factors that will continue in 2020:
1. Yield Premium
Even with yield compression in recent years, most alternative assets trade at higher cap rates than conventional real estate. For example, seniors housing (excluding nursing care) and student housing had average cap rates of 6.3% and 6.1%, respectively, in 2019 compared with multifamily’s 5.5%, according to Real Capital Analytics. Similarly, the average cap rates for life sciences and self-storage acquisitions were both about 6.1%.
2. Rising Market Demand
The sustained economic expansion over the past 10 years has been a major driver of market demand for alternative assets. Even more powerful, however, have been the structural changes in business, technology, demographics and society leading to significant growth in market demand for most alternatives.
The growing use of technology has created near exponential growth in demand for off-site cloud storage and data center facilities. Demand for life sciences facilities and medical office buildings has been rising due to technological advances in medicine, changes in how health care is delivered and an increasingly older population. Self-storage has benefitted from individuals and households having smaller homes or remaining in multifamily housing longer.
Demand for seniors housing has not risen dramatically this decade, but this will change over the next decade as baby boomers reach ages traditionally appealing for seniors housing. The average age of a new resident in an independent-living community is the mid-80s and the oldest baby boomer will turn 74 in 2020. However, the oldest baby boomers represent the target market for active-adult and other age-restricted rental housing.
Student housing investment opportunity has been driven, in part, by the continued need to update or replace outdated student housing facilities at four-year colleges and universities. Growth in student housing demand, however, has been modest due to flat enrollment nationally. Yet there is wide variation in enrollment, with many colleges bucking national trends and creating good investment opportunities.
3. Expanded Product Availability
The specialty sectors have provided investors with another avenue for investment, particularly important in the competitive U.S. investment landscape over the past several years.
4. Portfolio Diversification
Multi-property investors, particularly institutional investors, demand property diversification in their portfolios. Diversification often can be accomplished through the traditional property types, but greater investment in alternatives has provided another avenue, especially with many investors typically overweighted in office and retail and unable to acquire enough industrial & logistics assets to meet goals.
Greater transparency in pricing, market performance and operations provides prospective investors with deeper understanding of specialty sectors and greater comfort in investing in them. Improved transparency should also mitigate risk. While coverage of the specialty sectors is not as rich as for the traditional property sectors, there is a rising number of information and performance measurements. Greater transparency will continue in 2020 and help make the specialty sectors more appealing to investors not thoroughly familiar with the product.
INVESTORS FACE THREE KEY CHALLENGES IN ALTERNATIVES
1. Scale & Limited Product Availability
Many investors, especially institutional buyers, need large transactions or the ability to build a sizeable portfolio to justify the learning curve and investment platform needed for alternatives investment. This often is not possible, since the specialty sectors remain quite small compared with the major real estate sectors.
Favorable economic conditions and increased demand over the past decade have resulted in a large supply of new specialty product. Most of this space has been readily absorbed, and the new supply has created investment opportunities. But a few specialty sectors now are oversupplied, which will give investors pause in 2020.
The two sectors where oversupply is more evident are self-storage and seniors housing. Robust construction of self-storage facilities in many markets led to modest rent declines in 2019. The seniors housing construction pipeline has slowed over the past two years, but not enough for occupancy to rebound. The sector had lower-than-usual occupancy and only modest rent growth in 2019.
Each of the alternatives has specialized operations, some of which are highly complex. In the case of seniors housing, management is intensive. Investors often partner with experienced operators for property management; nevertheless, investors need additional expertise.
The investment allure of alternatives will remain very strong in 2020, despite these industry challenges. Specialty-sector investment in 2020 should match the $59 billion annual average of the past six years and account for 12% of total U.S. real estate investment.
U.S. Outlook by Sector
U.S. GDP growth will slow to between 1.5% and 2% in 2020, down from an average of 2.5% over past five years.
U.S. GDP growth will slow notably next year as various issues create higher levels of uncertainty, including the ongoing U.S.-China trade conflict, slowing global growth and a presidential election. Barring any unforeseen risks, we assess that a recession will be avoided, thanks in large part to the stimulatory effects of the Fed’s rate cuts in 2019. Slow growth will continue in 2020, broadly supporting already strong property market fundamentals.
Investment volume in 2020 should total between $478 billion and $502 billion, making it one of the strongest years on record.
Amid slower economic growth and global uncertainty, U.S. commercial real estate will remain a haven for investment in 2020. Greater investor caution and buyer-seller disconnects on pricing could moderately reduce volume from 2019 levels. Cap rates should be broadly stable, with slight compression for multifamily assets and slight increases for the other major sectors for an average spread of about 260 bps over 10-year Treasury yields next year. Investors should not count on significant appreciation returns, but income returns will remain steady.
Demand for office space will remain strong in 2020. Flexible space inventory will continue to increase, but at a slower pace.
Despite continued positive absorption of office space in 2020, rent growth will slow and vacancy will increase. Leasing activity will remain driven by tech tenants, benefiting markets like San Jose, Austin and Salt Lake City. Flexible office providers will strategically expand their footprint but a drawback by WeWork will significantly slow expansion from previous years. CBRE’s forecast is for 51.1 million sq. ft. in completions, a 70-bps increase in vacancy and 1.6% rent growth.
Absorption gains will be limited in 2020, with available supply outpacing demand. Nevertheless, rents will rise by 5%.
Despite some softening in the industrial & logistics (I&L) market, overall fundamentals will remain strong due to continued e-commerce penetration and demand for logistics space. Rent growth will be driven by newly constructed facilities and infill properties. Although there are potential trade-related risks, resilient consumer spending will buoy the I&L market and mitigate any tariff effects on major hubs relying on port activity.
Total U.S. retail sales increased by 3.5% year-over-year in Q3 2019 to $1.57 trillion, however more modest growth is expected in 2020 to $1.55 trillion.
Total U.S. retail sales growth is expected to slow in 2020, as consumers become more cautious. Positive net absorption and rent growth in most U.S. markets will be spurred by a lack of new supply and thousands of retail store openings. Malls are benefiting from the refreshing influence of Generation Zers, who prefer to shop in stores and are driving traffic back to brick-and-mortar retail. Many retail assets will convert to mixed uses, creating communities and thriving town centers.
The multifamily vacancy rate will edge up by 20 basis points to 4.5% in 2020, remaining under its long-term average of 5.1%.
Multifamily is positioned for continued favorable performance in 2020 but will experience some cooling due to new supply outpacing demand. Completions will match peak levels of recent years. New and potential rent control legislation will remain an industry concern. The best opportunities are in suburban markets, smaller metros and metro leaders, including Austin, Atlanta, Phoenix and Boston.
Interest in specialty sectors will continue, with alternatives accounting for more than 12% of all commercial real estate investment in 2019.
Investment in alternative or specialty sectors has risen steadily in recent years and will continue to attract high levels of investor interest and capital in 2020. Total investment in 2020 will come close to the annual average of $59 billion since 2014 and represent 12% of all commercial real estate investment, up from only 6% at the peak of the last cycle. Alternatives acquisition volume in 2020 likely will match this level.
New deliveries will increase the primary data center markets’ total inventory by 17.3% in 2019, increasing the competition between certain markets in 2020.
The wholesale data center sector continues to evolve as flexibility and agility within IT and real estate strategies drive decisions. Transaction volume remains driven by the adoption of Hybrid IT/multi-cloud access strategies by users. Adding momentum headed into 2020, network connectivity should remain a critical component of overall IT and real estate decisions. Demand will continue as users right-size and adapt their portfolios to handle current and future technologies, such as high-performance computing (HPC) and 5G.