U.S. Research Report

CAPITAL FLOWS 2016 Year-End Review and 2017+ Outlook

U.S. Property Markets Still Robust but Approaching Top of Cycle Andrew J Nelson, Chief Economist | USA

Commercial property transactions remained robust last year, if down from the historic level reached in 2015, with multifamily extending its lead as the preferred property type. In addition to strong property fundamentals, real estate capital markets continue to benefit from low interest rates, which reduce acquisition costs and render some alternative investments less compelling. The U.S. is also viewed as a safe haven and a relatively strong economy, encouraging demand from foreign buyers.

At the same time, record pricing in many markets — particularly for multifamily and office buildings in major metros — is deterring some buyers, slowing appreciation and reducing or even reversing capitalization rate (cap rate) compression. Overall, we expect commercial real estate sales to remain healthy in 2017 and into 2018, as investor demand remains strong and many investors have ample stockpiles of capital at their disposal. But rising interest rates and frothy prices in major markets seem likely to moderate volumes and push more activity into secondary markets — a trend that gained momentum last year.

Policy changes expected out of Washington this year — including a major stimulus package of infrastructure spending and tax cuts, as well as tax and regulatory reform — have the potential to significantly impact property fundamentals and the broader investment landscape. Too little is known about the parameters of these changes for definitive forecasts, but investors will want to pay close attention.

Key Observations

> Sales volumes last year fell short of the near-peak level reached in 2015 but still were among the strongest ever logged, particularly for single-asset transactions.

> Multifamily is now firmly the preferred property type, displacing offices, which long held the top spot. Apartments have gained on the strength of favorable demographic trends and shifts in lifestyle choices, while offices have lost some appeal as tenant demand has been below par in this cycle.

> Industrial is gaining at the expense of retail, reflecting the impacts of e-commerce, but warehouse transactions have been limited by a paucity of quality product offered for purchase.

> Investment momentum is shifting from primary to secondary metros, and to a lesser extent, from central business districts (CBDs) into inner suburban markets. Blame sticker shock in reaction to elevated pricing in top markets. This geographic shift in investment flows is manifesting in property pricing. Appreciation last year in secondary markets was narrowly greater than that in primary markets for the first time since 2012.

> Overall, appreciation is slowing and moderating returns. Operating fundamentals are still generally improving, if more gradually, generating solid income returns, but total returns will continue to slide as cap rates flatten or rise.

> Foreign investors continued to invest heavily in U.S. property markets in 2016 and early 2017, but exhibited greater preference for trophy assets in the best markets relative to their domestic counterparts. China more than doubled its investment in the U.S. last year, while Canada and Singapore pulled back. But new constraints on Chinese investment abroad may cut their U.S. demand.

> We expect foreign capital sources to maintain or increase their presences in U.S. property markets in 2017, as returns are expected to remain relatively attractive on a global basis. Broader tax exemptions for foreign investors adopted late last year should encourage further offshore investment in the U.S.

2 U.S. Capital Flows Research Report | 2016 Year-End Review and 2017+ Outlook | Colliers International

U.S. Transaction Volumes (Deals > $2.5 million)

Source: Real Capital Analytics

Transaction Volumes Still Robust but Down from 2015

With the U.S. economy in its seventh consecutive year of economic expansion, commercial property markets continued to command strong investor demand in 2016, though exhibiting some initial signs of fatigue. Some market participants were undoubtedly disappointed by the drop in overall sales last year, but the market was quite healthy by historical standards.

The total sales volume last year was among the highest ever recorded, though falling short of the near-peak level reached in 2015. In fact, excluding the big drop in portfolio and entity sales, single-asset transactions last year virtually matched the record volume recorded in 2015.

After a slow start, the year ended with an annual transaction volume of $492 billion, down 10% from the $547 billion achieved in 2015, based on data from Real Capital Analytics (RCA). But 2016 was hardly weak. Its sales volume was up almost 14% over 2014, which had served as the high-water mark in this cycle until 2015’s tremendous performance.

Transaction Volumes by Property TypeApartments had the strongest year of any property type and was the only sector to register year-over-year gains in transaction volumes (+3.9%) and one of only two sectors, along with offices, with market-share gains over 2015. Multifamily gained favor as the first property sector to recover after the recession, while shifting demographic and lifestyle choices have only strengthened its performance. Apartments extended its lead as the preferred property type with 32.4% of all property sales, up 4.4% from the prior year and up an astonishing 7.1% over its long-term average of 25.3%.

Office gained 1.5 percentage points in 2016 to account for 29.1% of all sales, but was down 8.1% from the prior peak in 2007. Offices are now the second-most popular property type by sales volume nationally, but have lost some of their luster for investors because absorption has been well below par in this cycle as firms reduce their space usage, even as the number of office workers has soared to new record levels.

Industrial sales transactions fell 24%, which is perhaps surprising given the strength of the underlying property fundamentals. Supply has been restrained in this cycle, while e-commerce is fueling significant shifts from retail to warehouse demand, yielding record absorption and rent growth for warehouses. However, anecdotal evidence suggests the relatively weak sales volumes — just 12.1% of overall property activity last year, below its long-term average of 13% — can be attributed more to the limited availability of quality product for sale rather than a lack of investor interest. With only limited construction by merchant builders, much of the new supply has been coming from REITs, which generally retain the new product for their own portfolios, meaning the product never comes to market.

On the other hand, retail continues to lose favor with both investors and tenants. With only 15.5% of sales last year, no property sector has lost more market share relative to its long-term average (19.6%, for a loss of more than 4 percentage points). The reason is clear: The nation no longer needs as much retail space, as consumers shop more online and retailers adopt strategies with fewer, smaller stores, idling much of the existing stock. In all, shopping center transactions fell almost 16% last year.

Finally, the volatile hotel sector lost some ground last year, with its share of sales falling to 7.3% on a 29% drop in sales. Even with these declines, however, hotel’s share of sales is still above its long-term average of 6.7%.

$0

$100

$200

$300

$400

$500

$600

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Office Industrial Retail Apartments Hotel Land

27%

14%

16%

28%

9%

4%

37%

10%

14%

19%

14%

5%

29%

12%

17%

33%

6%

4%

Billi

ons

Transaction Volumes by Property Type2016 VOLUME($ BILLIONS)

2015-2016 CHANGE IN VOLUME

Apartments 159.4 +3.9%

Office 142.9 -5.1%

Retail 76 -15.9%

Industrial 59.4 -24.0%

Hotel 35.9 -28.7%

Land 18.1 -25.6%

Total 491.7 -10.2%

Single Asset 368.8 -0.8%

Portfolio/Entity 123 -30.1%

Transaction Shares by Property Type

2016 SHARE 2016 SHARE VS. AVERAGE

Apartments 32.4% 7.1%

Office 29.1% -2.8%

Retail 15.5% -4.1%

Industrial 12.1% -0.9%

Hotel 7.3% 0.6%

Land 3.7% 0.2%

Source: Real Capital Analytics and Colliers International

Source: Real Capital Analytics and Colliers International

3 U.S. Capital Flows Research Report | 2016 Year-End Review and 2017+ Outlook | Colliers International

Transactions by Metro and SubmarketLast year saw a marked shift in investments from primary to secondary markets as elevated pricing in the leading markets seems to be nudging investors to seek out greater returns beyond the usual metros. The primary markets comprise New York, Chicago, Los Angeles, Boston, Washington, D.C. and San Francisco. However, in the industrial sector, the primary markets are Los Angeles, Dallas, Chicago, Northern New Jersey, San Jose and Riverside. In fact, secondary markets captured a greater share of investment dollars (44.3%) than the primary markets (42.3%) for the first time in more than a decade. Among the top transaction metros outside the six largest: Seattle, Atlanta, Denver and Phoenix.

Deal flow in secondary markets actually grew by 3.5% in 2016, while falling 11% in major markets. In sum, the share of transactions in primary markets fell 3.1 percentage points while secondary market share rose 3.2 percentage points. The tertiary market share was essentially flat at 13.4% of the market.

Share of Investment Volumes

In a related trend, last year saw a continued shift of investment dollars in the office sector toward suburban markets (56.8% of total sales) and away from CBD office (43.2% of total sales). As recently as 2014, their shares were virtually equal. Similarly, the garden apartment share of multifamily investment rose last year at the expense of mid- and high-rise apartments. Garden apartments tend to be located in suburban markets while higher-rise products are more typically found in cities. In both cases, lofty CBD pricing seems to be the biggest reason.

One exception to this trend: Full-service hotels, generally located in cities, saw a strong increase in its share of the hotel market (+3.8%), while the share for limited-service hotels fell by an equal amount. However, this sector is much smaller ($35 billion in sales in 2016 vs. $143 billion in office sales and $159 billion in multifamily) and thus not as significant.

In terms of individual metros, deal flow volumes largely mirror population centers, with the top four spots largely unchanged from 2014 and 2015. Manhattan maintained its hold on the top spot, with more than $40 billion in transactions last year — though down 30% from a year earlier. According to RCA, Manhattan accounted for seven of the top 10 deals last year and 13 of the top 20, including the four largest: 787 Seventh Avenue ($1.94 billion), Citigroup Center ($1.88 billion), the PaineWebber Building ($1.65 billion) and 550 Madison Avenue ($1.42 billion).

Los Angeles remained in second place with $28 billion in transactions, up 5% on the year, while Dallas ($21 billion) edged out Chicago ($20 billion) in the next two places. Atlanta ($17.4 billion) remained in the fifth spot, while Seattle nudged ahead of Boston for sixth and seventh. San Francisco remained in eighth, ahead of Denver — which jumped from 17th in 2015 to ninth. Phoenix rose one spot from last year to crack the top 10. Among the big losers last year: Houston, Northern New Jersey and the Washington, D.C. suburbs, all of which fell in the ranking.

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Primary Secondary Tertiary

Top U.S. Metro Destinations for Cross-Border and Domestic InvestorsCROSS-BORDER DOMESTIC TOTAL

New York City 18,536,748,485 New York City $50,824,594,746 New York City $69,361,343,232

San Francisco 6,323,408,814 Los Angeles $39,893,371,411 Los Angeles $45,640,920,360

Los Angeles 5,747,548,949 San Francisco $29,252,926,602 San Francisco $35,576,335,416

Washington, D.C. 3,613,488,442 Dallas $19,621,045,715 Dallas $21,916,790,398

Chicago 2,604,590,076 Chicago $18,293,391,397 Chicago $20,897,981,473

Miami/South Florida 2,517,433,722 Washington, D.C. $16,997,090,508 Washington, D.C. $20,610,578,949

Dallas 2,295,744,683 Miami/South Florida $15,965,529,959 Miami/South Florida $18,482,963,681

Seattle 2,057,485,080 Atlanta $15,709,315,990 Atlanta $17,687,580,367

Atlanta 1,978,264,376 Seattle $13,822,772,866 Seattle $15,880,257,946

Phoenix 1,863,825,371 Boston $13,715,740,973 Boston $15,512,766,864

U.S. Total $65,363,299,358 U.S. Total $427,918,107,546 U.S. Total $493,281,406,904 Source: Real Capital Analytics

Source: Real Capital Analytics

4 U.S. Capital Flows Research Report | 2016 Year-End Review and 2017+ Outlook | Colliers International

Buyers and SellersContinuing a trend dating back to 2014, most domestic investor groups were once again net property sellers last year, with only private equity investors acquiring modestly more assets than they sold. In aggregate, RCA found that domestic investors sold 7% (-$31.3 billion) more than they bought last year.

By contrast, foreign investors were again strong net buyers (+$31.6 billion), acquiring almost twice as much property as they sold. In fact, cross-border investors have been net buyers every quarter since Q2 2013. Over this same period, all other buyer cohorts generally have been net sellers. Note that the small difference between the 2016 net seller and net buyer figures reflects unknown buyers.

Private investors remain the largest group of buyers, accounting for 47% of all volume in 2016, with institutions and equity funds remaining in second place with 27% of all acquisitions. However, REITs relinquished their long hold on third place. After averaging some 15% of all sales in recent years, the REIT share dropped to 8% last year. Offshore buyers moved into third place with 14% of acquisitions, well above their 10% average. Although REITs have been raising capital, their share of the investment pie continues to drop along with their share prices, while assets under management among institutional investors and sovereign wealth funds rise, leaving REITs with relatively less fire power with which to compete for properties.

Foreign vs. Domestic DemandLast year saw major shifts in the sources of foreign capital as China surged past Canada to outpace all other countries. Chinese entities bought an estimated $13.8 billion of U.S. commercial real estate during 2016, more than double their 2015 investment and representing a fifth of all foreign property investment. Major acquisitions included the $5.5 billion hotel portfolio purchase by Anbang Insurance Group — the second-largest property transaction of 2016 — and a $2 billion hotel portfolio purchase by China Life Insurance, as well as such notable assets as the former McGraw-Hill headquarters and One New York Plaza, both in New York.

Meanwhile, Canadian purchases dropped to $13.4 billion, about half of the country’s 2015 U.S. investment total. Germany moved up to third place despite a 14% drop in acquisitions. South Korea jumped from eighth place to fourth as investments rose 17%, while Singapore fell from second to fifth as their acquisitions plunged 77%.

Relative to domestic investors, foreign buyers tend to focus even more on the leading markets. As noted previously, the top six metros accounted for 42.3% of investment dollars last year. But there is a huge spread between U.S. and foreign buyers: the top-six share is just 39.5% among domestic investors but soars to 60.8% for offshore investors.

Manhattan is a particular attraction for foreign investors, accounting for 22% of their acquisitions last year, compared to only 8.2% overall. And while the top-six market share fell last year among domestic investors (-3.5%), the share rose for foreign buyers (+0.8%). With pricing so elevated in the top markets, it is clear foreign entities are less motivated than U.S. investors by short-term yield.

Capital RaisedAlthough REITs were net sellers in 2016 as they were in 2015, they still raised more than $69.3 billion in new capital, their greatest haul since 2013. Half of the capital was raised through unsecured debt, with most of the rest was raised through issuing shares.

Meanwhile, Preqin’s 2017 Global Real Estate Report finds that real estate investment funds were sitting on an estimated $237 billion in dry powder in 2016 — that is, uncommitted funds available for investment — up from $229 billion at the end of 2015 and $136 billion at the end of 2012. These figures, which include both domestic and foreign sources, point to both the growing interest from institutional investors as well as the challenges in finding product that meets their investment criteria.

$(30)

$(20)

$(10)

$-

$10

$20

$30

$40

Cross-Border Inst'l/Eq Fund Listed/REITs Private User/other

Billi

ons

H2 2014 H1 2015 H2 2015 H1 2016 H2 2016

Net Investment by Sector

Source: Real Capital Analytics

Transaction Volumes by TypeCOUNTRY 2016 TOTAL VOLUME 2016 RANK 2015 RANK

China $16,206,970,675 1 3

Canada $11,629,412,303 2 1

Germany $5,578,480,419 3 5

South Korea $3,805,475,996 4 8

Singapore $3,349,443,858 5 2

Switzerland $3,273,858,136 6 9

Qatar $3,198,690,316 7 7

Japan $2,609,222,717 8 15

Israel $2,498,939,500 9 14

Hong Kong $2,346,626,159 10 13

Other $10,791,377,196

Total $65,288,497,275 Source: Real Capital Analytics

5 U.S. Capital Flows Research Report | 2016 Year-End Review and 2017+ Outlook | Colliers International

Property Prices and Returns

Property pricing continues to be a tale of two market types, with significant differentials between the major markets and all others. Two years ago, we reported that pricing in the major markets — the top six metros — had already exceeded its prior peak, even after adjusting for inflation. Prices have continued to rise since then, but prices in the secondary markets still have not reached new peak levels overall.

Primary MarketsAccording to the Moody’s/RCA Commercial Property Price Index (CPPI), real prices (after adjusting for inflation) in the top six markets were 20.6% above their prior peak at the end of 2016, but the pace of appreciation is slowing commensurate with the lower investment volumes. Prices rose 5.8% last year, below the 10.6% gain in 2015 and 17.1% the year before, and preliminary figures show prices falling slightly in early 2017. These indices of matched pairs provide a better gauge of appreciation than simple comparisons of price per square foot of assets sold, where the quality of product varies over time.

Real Property Prices Over Time | Indexed to 2001Top Six U.S. Metro Markets

New price peaks have been attained in the major markets in all sectors except suburban office, which is down 15%, but the gains since the recession vary considerably by property type. Leading the pack by far is multifamily, where prices are up more than 50% beyond the prior peak, followed by CBD office, where prices are up 38%. Both saw price gains of about 9% last year, which generally reflects their relative popularity among investors.

Similarly, industrial pricing is outpacing retail for the first time. Last year, the industrial price index in the major markets rose 12% while it was about flat for retail, reflecting the relative operating performances of the two sectors. The price index for warehouses in the major markets is up 7.5% over the prior peak, compared to 1.6% for shopping centers.

Secondary MarketsThe situation is much different in the non-major metros, where the inflation-adjusted index for all property types still stands at 6.7% below its prior peak reached in August 2007. However, the differential with the top six markets is starting to narrow, if slowly, as appreciation last year in the secondary markets (6.7%) was narrowly greater than those in the primary markets (5.8%) for the first time since 2012.

The lower cumulative appreciation in the secondary markets is reflected across all the property sectors. Only multifamily exceeds its prior peak, though CBD office in these secondary metros is getting close. But cumulative gains in these sectors are far lower than in the primary markets, as they are for industrial and retail product as well. Retail pricing is particularly weak, still more than 23% below its prior peak, as shopping centers in the secondary markets have been particularly hard hit by the growth of e-commerce and shifting retailer strategies, leaving many centers with pervasive vacancies.

Capitalization Rates and ReturnsAs we warned last year, capitalization rates seemed to have hit cyclical lows in 2016, generally ending the year a little higher than a year prior. The two modest Federal Reserve interest rate hikes likely had little impact. Rather, the record pricing in the major markets seems to be meeting increasing resistance from buyers, particularly domestic investors who continue to be net property sellers.

Based on transactions in the NCREIF Property Index (NPI) — the best indicator for institutional-quality real estate — cap rates rose for all four major property types, ranging from 15 basis points (BPS) for office to 50 BPS for retail, with a weighted average of 22 BPS. Cap rate metrics can be volatile, depending upon which assets happen to transact during a period, and thus are better measures for direction than absolute levels. But that upward direction is now clear.

75

95

115

135

155

175

195

215

235

255

275

4Q00

2Q01

4Q01

2Q02

4Q02

2Q03

4Q03

2Q04

4Q04

2Q05

4Q05

2Q06

4Q06

2Q07

4Q07

2Q08

4Q08

2Q09

4Q09

2Q10

4Q10

2Q11

4Q11

2Q12

4Q12

2Q13

4Q13

2Q14

4Q14

2Q15

4Q15

2Q16

4Q16

Multifamily Retail Industrial CBD Office

CBD Office = +38.0%

Multifamily = +50.8%

Retail = +1.5%

Industrial = +7.4%

Source: Moody’s/Real Capital Analytics CPPI and Colliers International

Source: Moody’s/Real Capital Analytics CPPI and Colliers International

Price Appreciation Rates by Market Type

ANNUAL APPRECIATION

MAJOR MARKETS

NON-MAJOR

MARKETSDIFFERENCE

2011 7.4% 2.3% 5.2%

2012 5.5% 6.3% -0.8%

2013 14.6% 11.5% 3.1%

2014 17.1% 14.7% 2.4%

2015 10.6% 9.9% 0.8%

2016 5.8% 6.7% -0.9%

INDEXED FIGURESPrior Peak 160.9 138.0

End of 2016 194.1 128.8

Difference 20.6% -6.7%

66 U.S. Capital Flows Research Report | 2016 Year-End Review and 2017+ Outlook | Colliers International

Cap rates were already at or below their historic lows at the start of 2016, leaving little room to fall further. Even with the recent Fed hikes, cap rates overall are still above their long-term average spread to the 10-Year Treasury, the most common measure investors use to gauge property cap rates. But cap rates are below their long-term average spread to Baa corporate bonds, which sophisticated investors increasingly use to gauge property cap rates — again suggesting property is pricy.

The good news for investors is that operating fundamentals are still improving, if more slowly, fueling solid income returns. But with cap rates rising slightly last year, appreciation and overall returns are falling. Returns in the NPI last year were still a healthy 8%, but below its long-term average of about 10% and down significantly from the outsized returns of the prior several years; the annualized average total return for the five years through 2015 was 12.1%. Expect returns to remain strong for at least another two years, if below the double-digit returns in recent years.

Interest Rates and Debt Markets

After finally hiking interest rates by a modest 25 BPS in December 2015 for the first time in more than a decade, the Federal Reserve waited another full year before raising rates another 25 BPS in December 2016 — despite setting expectations for several hikes last year. Fed officials ultimately found that economic conditions did not justify further tightening. Inflation and wage growth remained well below Fed targets, while the moderate GDP growth — at 1.6%, the lowest of this expansion — did not suggest any need for the Fed to accelerate its pace of rate hikes.

That changed with the presidential election. Almost overnight, the dollar and interest rates started rising, as investors presumably expect the anticipated stimulus and other economic policy measures from Washington this year to be inflationary and to boost economic growth. Accordingly, after trading in a relatively narrow range of 1.5% to 1.86% in the three months prior to the election, yields on 10-Year Treasury notes spiked to over 2.5% within a few weeks after the election, its highest level in over two years. Rates have since remained within an elevated range of 2.3% to 2.6%.

In turn, the Fed has adopted a decidedly more hawkish outlook, signaling a total of three hikes each in 2017 and 2018, the first of which was just confirmed at its March meeting. Markets and economists generally concur. The average forecast from Consensus Forecasts™ shows the Federal Funds Rate rising from a mid-point of 0.875% (a target range of 0.75% to 1%) currently to 1.375% (target range of 1.25% to 1.5%) at year end, implying two more 25-basis-point hikes this year. Meanwhile, the consensus forecast for the 10-Year Treasury has risen to 2.9% at the end of 2017, up 60 BPS since the election, and to 3.4% at the end of 2018.

Mortgage Rates and Lending ActivityThus far, the impact of interest rates on the investment market has been subdued, though that may change with the Fed’s more concerted tightening. Mortgage rates for commercial properties tracked by RCA (7–10-year fixed) ended 2016 at 4.5%, little changed over the past two years and still well below the cyclical peak of 7.3% in early 2009. Similarly, rates for multifamily mortgages ended the year at 4.1%, also little changed over the past two years and well below the cyclical peak of 6.3% in late 2008.

Commercial mortgage originations (including multifamily) were essentially flat last year at an estimated $502 billion after surging by 26% in 2015, according to the preliminary Commercial/Multifamily Real Estate Finance Forecast by the Mortgage Bankers Association (MBA). Meanwhile the amount of commercial real estate mortgage debt outstanding grew by almost 5% to $2.96 trillion in 2016.

Commercial banks continued to hold the largest share of commercial mortgages in 2016, with $1.2 trillion or 40% of the total, followed by the government-sponsored enterprise (GSE) portfolios with 17%, which increased originations by 7%. However, the commercial mortgage-backed securities (CMBS) share fell as CMBS originations dropped by 15%. Finally, life insurance companies and pension funds saw their share rise slightly, though their originations were just even with 2015.

Finally, mortgage delinquency rates for all major lender groups remain at near-zero levels except CMBS, and at or very near their low points going back to at least 2000, again except for CMBS.

Note: P = Preliminary, F = Forecast

Sources: Mortgage Bankers Association (as of February 19, 2017) and Colliers International

Commercial/Multifamily Mortgage Originations2015 2016P 2015-2016 2017F

Life Companies and Pension Funds

79 79 +0.0% 81

GSEs and FHA 110 118 +7.3% 121

CMBS 99 84 -15.2% 90

Banks and Other 216 220 +1.9% 223

Total 504 502 -0.4% 515

7 U.S. Capital Flows Research Report | 2016 Year-End Review and 2017+ Outlook | Colliers International

Outlook for the Remainder of 2017 and Beyond

It was perhaps inevitable that commercial real estate investment activity would pull back last year after the blistering, near-record pace in 2015. But transaction volumes remained robust and pricing resilient last year and into this year, while indications suggest continued strength going forward. Some of these promising indicators include:

> Growth forecasts for the U.S. economy have inched up since the election, while the International Monetary Fund, among others, is finally predicting stronger global growth in 2017 after several years of anemic figures.

> Institutional investors are sitting on vast reserves of capital raised for acquisition, while REITs continue to raise fresh capital on top of the cash available from their net dispositions over the past two years.

> Investor surveys show strong, even increasing, demand for product from domestic and especially foreign sources. For example, the annual survey by the Association of Foreign Investors in Real Estate (AFIRE) reports that two-thirds of respondents plan to increase their investment in the U.S. this year, and almost all others will maintain their allocations.

> Debt should be readily available for investors seeking leverage. More than three-quarters of respondents in the MBA’s annual Commercial Real Estate Finance Outlook Survey for 2017 report “strong” or “very strong” appetite to make new loans, and the MBA forecasts that originations will rise 2.6% this year over last.

> Mortgage delinquency rates remain at near-zero levels for all major lender groups except CMBS.

All of these factors bode well for the U.S. property investment market. And while “Brexit” is still two years away, the U.S. market may benefit from Britain’s move out of the European Union, as foreign investors will likely find the U.S. to be even more of a safe haven.

Nonetheless, there are also clear signs that U.S. property markets may be close to cresting:

> Half of lenders in the MBA’s annual survey see willingness to lend for commercial real estate “weakening” this year, while only 12% see conditions “strengthening.” This outlook is decidedly less bullish than in the 2016 survey.

> Appreciation has slowed from that in recent years in both primary and secondary markets. Colliers brokers report that even where pricing is holding at record levels for prime assets, the pool of serious bidders on individual deals is shrinking — often a precursor to market peaks.

> In part, this slower appreciation reflects lower absorption rates for most property types, even if property fundamentals continue to strengthen. After more than seven years of continuous, moderate growth, the economy is likely much closer to the end of its expansion than the beginning.

Some investors have also grown more cautious as they fear our trading partners might engage in retaliatory trade policies in response to any shifts in U.S. policy.

Most importantly, there is now a broadening consensus that the era of ultra-low inflation and interest rates is ending, altering the investment calculus for investors. The Fed has clearly signaled it expects to hike rates more aggressively for at least the next two years, and unlike last year, the markets apparently agree. Rates on Treasury notes began rising immediately after the election in anticipation of higher inflation and coming Fed hikes.

Of course, Fed tightening need not be a presage of rising cap rates or falling returns. Indeed, some of the best periods for the commercial real estate sector have occurred when the Fed has been pushing up rates aggressively, such as in the last property boom from 2004–2008.

But conditions now are much different. When the Fed last started tightening in early 2004, property markets had only just started to recover from the 2001 recession. Prices were much lower (and rising), cap rates were much higher (and falling) and vacancy rates were much higher (and falling). With appreciation now easing, cap rates flat to rising and space absorption slowing, rising interest rates should exact a greater impact on property conditions and returns.

With interest rates rising, debt costs will become more of a constraint on demand for product at some point. However, this isn’t likely in the very near term as even with the anticipated hikes this year and likely market pricing for mortgages, rates will still be quite moderate by historical standards. Rising interest rates also will make bonds more compelling, eventually cutting into property demand.

Tax Law ChangesAnother consideration for investors is the possible series of tax law changes that could have profound implications for the property sector. For example, the proposed bill from the House of Representatives removes deductions for debt interest payments and would eliminate depreciation for commercial property. Instead, investors could expense the entire cost of buying a property (excluding land) in the first year of acquisition, with carry-forward losses if necessary. This change would effectively eliminate tax-free 1031 property exchanges.

However, it must be stressed that any changes to tax law should be regarded as highly speculative at this point, as no legislation has even been introduced, much less adopted. Nonetheless, the dynamics in Washington — with one party controlling the White House and both houses of Congress — suggest that some action is likely by late this year or next year. Accordingly, property investors will want to pay close attention to the legislative process and consider adjusting their investment strategies accordingly.

88 U.S. Capital Flows Research Report | 2016 Year-End Review and 2017+ Outlook | Colliers International8 North American Research & Forecast Report | Q4 2014 | Office Market Outlook | Colliers International

Copyright © 2017 Colliers International.The information contained herein has been obtained from sources deemed reliable. While every reasonable effort has been made to ensure its accuracy, we cannot guarantee it. No responsibility is assumed for any inaccuracies. Readers are encouraged to consult their professional advisors prior to acting on any of the material contained in this report.

Colliers International 101 Second Street, 11th FloorSan Francisco, CA 94105+1 415 788 3100colliers.com

FOR MORE INFORMATIONAndrew J Nelson Chief Economist | USA+1 415 288 7864 andrew.nelson@colliers.com

RESEARCH CONTACTPete Culliney Director of Research | USA & Global+1 212 716 3698 pete.culliney@colliers.com

Conclusions

Demand drivers for U.S. investment property are still quite favorable and should keep property values high and transaction volumes healthy for the remainder of 2017 and into next year. But investors should expect more moderate returns than we have enjoyed in recent years, as both rising interest rates and record pricing in major markets will limit further appreciation. Moreover, investors will continue to pursue more favorable returns in secondary metros and superior suburban markets at the expense of CBDs in the leading markets, where prices have been driven up the most.

With prices so high, domestic investors are likely to continue to be net sellers, leaving foreign investors to make up the difference. Fortunately, offshore capital sources are maintaining a strong interest in U.S. property markets, with low initial yields presenting less of a deterrent for many of these investors. But pressures from Beijing and devaluations of the Chinese currency may limit investment out of China this year, as discussed more fully in Colliers’ 2017 capital flows report for the Asian market.

Finally, investors should prepare for a new period of higher inflation and interest rates, as well as a growing risk of recession. Higher inflation will favor multi-tenant buildings with shorter lease terms, but investors more concerned with protecting against the risk of recession will favor top-credit tenants under longer-term leases. And with rising interest rates, owners will want to lock in favorable financing terms this year.