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Investors Are Turning To Debt Markets, Value-Add Assets In Search Of Solid Returns

    Extended cap rate compression, elevated supply pressures, a frustrating bid-ask spread and the length of this cycle are expected to stifle transaction volume this year.

    JLL Senior Director of Investor Research Sean Coghlan said these factors combined are causing investors to get creative. 

    “We are seeing an increase in investors accessing real estate through investments in debt, which can be a more secure part of the capital stack,” Coghlan said. “Debt markets are open and active, with CMBS lending strong and debt funds having emerged notably.” 

    As investors increasingly shift their focus to debt capital markets, they are doubling their fundraising efforts to make value-add and opportunistic investments, which JLL predicts will remain a common theme throughout 2018, according to its Investment Outlook report.

    “In the current low-yield environment, value-add properties offer investors the opportunity for higher returns. Value-add funds are stepping in to invest where they can create the most value, whether through repositioning a building or through creating incremental rent growth and targeting a longer hold period,” Coghlan said. 

    Though transaction volume advanced 4.7% in the first quarter to $98.7B, led by hotel, industrial and multifamily acquisitions, JLL expects deal volume to taper off throughout the remainder of the year.

    “Investors are increasingly opting to hold and refinance their assets to take some chips off the table and hold them longer, while focusing on growing their NOI through asset management strategies amid more muted opportunities for capital appreciation,” Coghland said.

    Read on to see how investors are deploying their capital in the core five property sectors. 

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    Robust supply levels remain a thorn in the side of the office sector. Though transaction volume was boosted by a handful of major transactions, including the sale of the Chelsea Market building to Google for $2.4B, deal volume still fell in Q1, declining by 5.6% to $29.5B year-to-date. JLL attributes the softening in investment activity in part to a pullback in cross-border deals led by foreign investors.

    Investment in both primary and secondary markets declined during the quarter, though market leaders say demand for opportunistic and value-add product in high-growth secondary markets is on the rise. The suburban office markets have a lot working in their favor, including more available land on which to build, cheaper rents for office occupiers, strong live-work-play synergy for aging millennials looking to start families, stellar public transit options and an abundance of value-add opportunities that, with the right assortment of amenities, could generate strong yields. 

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    Despite developers delivering 91,000 units during the first quarter and both rent growth and vacancy rates remaining unchanged, a large jump in multifamily transactions year-to-date underscored renewed interest in the sector in the beginning of this year. Multifamily transactions advanced 32.2% compared to Q1 2017 to $33.7B year-to-date. Private investors accounted for the largest chunk of investment during the quarter with high net worth individuals looking for stable cash-generating assets in which to store their capital. Investment in high-end Class-A product in gateway markets rebounded this year, though aggressive development in the urban core could make for riskier bets moving further into 2018.

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    Though strong retail fundamentals in Q1 may have helped temper investors' wariness regarding the health of the sector, flat rents and vacancy rates did not jump-start investment activity in the segment. Amid the massive wave of retail bankruptcies and stores that have closed this year, retail transactions plummeted 30.9% in Q1 year-to-date. JLL posits there could be a rebound in the sector later in the year sparked by institutional investors in search of solid returns, such as Brookfield's $9.2B acquisition of GGP and Unibail-Rodamco's bid to acquire shopping center giant Westfield Corp. for $33B, which the majority of Westfield shareholders have voted in favor of. 

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    Hotel investment is on the rebound. The sector experienced robust investment activity during Q1 thanks to renewed demand for corporate and leisure travel, causing occupancy to hit 66.4% during the period. Investment sales advanced 78% year-to-date to $8B largely due to portfolio transactions. Thirty-four percent of transactions during the period were made by private equity firms, while cross-border investors from Canada and China accounted for 26% of transactions. JLL anticipates investment activity will be stifled later this year due to the industry’s expensive labor costs and hoteliers’ inability to increase profit margins and return decent yields for investors. 

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    Industrial real estate transaction volume advanced 20.8% in Q1 to $15.9B, and JLL does not anticipate a slowdown in momentum any time soon.“The current momentum is expected to propel 2018 to the second highest annual volume on record,” the brokerage service firm reports. Vacancy rates dropped an average 20 basis points to a record-breaking 4.8%, even with roughly 57M SF of new product delivering during the quarter and JLL reports new supply is slated to surpass 200M SF by the end of the year. Institutional investors like Blackstone Group continue to drive investment in this space, and consolidation among industrial REITs, such as Prologis' acquisition of DCT Industrial Trust for $8.4B, is a running theme this year. JLL cautions that looming trade war talks and extended cap rate compression could pose risks for investors in this segment moving forward.