US real estate risk premium increases as uncertainty weighs on sentiment

Fundamental strength in the US economy acts as a stabilising factor by supporting income growth at the property level. A tight labour market and optimistic confidence measures reinforce UBS’ expectations for relatively good occupancy rates and continued rent growth in the US real estate sector.

In its quarterly global outlook, UBS wrote:

“Beginning in early 2016, US real estate entered a widely-anticipated period of income-driven performance. On the whole, US properties are appreciating at about the pace of inflation. Appreciation relates back to the positive rent growth generated by properties, as opposed to the out-sized influence of capital flows the US experienced in 2014 and 2015.

“Income-generated performance is consistent with a long-term expectation for private commercial real estate investments. Looking more closely at the drivers of income, rent growth is the true powerhouse behind the gains. Property-level income growth should outpace today’s modest inflation even as the pace of growth moderated in recent years.

“Even though 2018’s rising interest rate environment reversed and long-term interest rates fell during 2019, uncertainty remains and the increased risk premium appears warranted. Capital investment into stabilised assets is increasing, an expected outcome in a long expansion. Debt and equity capital is seeking growth strategies, and existing assets are under pressure to compete with new construction. Investors should pay careful attention to the risk-return expectations for incremental capital.”

Investment activity US commercial real estate sales volume was $499 billion in the 12 months to Q3, up slightly compared to the prior 12-month period. During the three quarters of 2019, the volume of hotel, office, and retail properties sales remained consistent with the previous two years. However, apartment sales volume has maintained a rising trend and industrial sales volume increased over the prior year.

Enduring low interest rates are supporting the low cap rate environment and cheap real estate debt. However, liquidity is not as abundant as the period prior to the lead-in to the last downturn.

UBS added:

“The spread between property yields and the cost of debt decompressed somewhat in 2019. However, banks must contend with a flat yield curve. When both short and long-term rates are nearly the same, it becomes difficult to pay depositors a market rate while charging a competitive interest rate on loans. On the whole, US debt markets can be described as operational but not excessive, which encourages development but not an abundance of supply.

“With little movement in cap rates, the downward move in Treasury rates widened the spread available on stabilised US real estate. While the real estate spread is no longer compressing, the higher risk premium seems warranted as uncertainty around future economic growth also increased. That said, there is no obvious distress in the market that might place stronger upward pressure on cap rates.”

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