Sunny With a Few Clouds
The forecast for commercial real estate markets in 2020 is promising, but investment will require sophistication to avoid potential pitfalls.
Turning the calendar over to a new year is a good time time to reflect and reassess. That holds true in commercial real estate, especially in reallocating capital and realigning investment strategies. There's no shortage of white papers and research on capital markets by all industry sectors of commercial real estate, ranging from banking and brokerage to debt and equity sources, but what today's CRE practitioner is searching for is a reconciliation of the plethora of data and conflicting views into an outlook that puts events and trends into perspective and paints a clear picture of what lies ahead in 2020.
Chapter 1: Heavy Investment in Debt
First, let's set the stage for this summary of the capital markets entering 2020. Chapter 1 begins against the backdrop of $4.36 trillion of investments on the debt side of the ledger, according to Moody's Analytics, the highest since before the Great Recession - from all the CRE lending entities, including REITs, pension funds, government-sponsored enterprises (such as Fannie Mae and Freddie Mac), construction lending banks, and permanent debt sources like CMBS. The U.S. economy is still chugging along into its 11th year of recovery (125 months at year-end 2019), with the November gross domestic product revisions back up to 2 percent - and December's surprising Bureau of Labor Statistics report showing 266,000 jobs created in November; U3 and U6 unemployment levels declining to 3.5 percent and 6.9 percent, respectively; and a 3.1 percent year-over-year wage growth. In addition, banks are well capitalized and producing gross revenues at levels that are the best in a decade. Also, key credit metrics, like CRE loan delinquency, are stellar.
The latest Mortgage Bankers Association's Commercial/Multifamily Delinquency Report shows CRE delinquency rates of just three basis points for life insurance companies; four and six basis points for Freddie Mac and Fannie Mae, respectively; and 45 basis points for banks. All these rates are down over the period and year-over-year.
As the nation heads into a presidential election year, how could conditions be any better and what could go wrong? Instead of resting on these laurels, let's look beneath the surface of this data and ask what signals warrant rethinking the direction and magnitude of real estate investment in 2020.
Chapter 2: The Vector Calibration
Vectors are well understood by rocket scientists as an invaluable mathematical function to determine both the direction and magnitude at which aircraft travel. Applying that to CRE, a vector calibration, in a modified application, determines where and how much investment is taking place. Think of the where - both geography and property type - as the direction aspect of the CRE vector and the how - by geography and property type - as the magnitude. Despite the whiplash to investment sentiment as a result of the tariffs implemented more than a year ago and a Federal Reserve that openly reverses course (four interest rate hikes in 2018 followed by three rate reductions in 2019), the ongoing hunt for yield in a negative-yielding global debt environment of more than $14 trillion, according to Bloomberg News, suggests that 2020 could be another year in which capital flows into U.S. commercial real estate remain elevated due to a compelling risk-reward yield premium.
Chapter 3: It All Starts With the Economy
Capital allocations take their cue from economic conditions, which is why an understanding of the underlying economic conditions at year-end 2019 is integral to forecasting the flow of capital into the industry for 2020. CCIM Institute posits that eight primary indicators have proven effective in determining continued economic growth or, conversely, the onset of a market correction - GDP; employment; consumer optimism and total retail sales; small business activity and optimism; corporate earnings; FDIC-insured bank lending activity and income growth; CMBS and macro-CRE loan performance and delinquency; and commercial property price indices. These metrics at the time of writing this article point to a stay-the-course outlook. However, some early caution signs have implications for 2H2020 and into 2021. If, for example, CRE debt concentration continues to rise or trade tensions don't abate, you need to have an alternative investment strategy at hand to change course.
GDP: Although U.S. GDP expansion slowed from 2.5 to 3.5 percent in 2018 to 2.0 to 2.5 percent through the first three quarters of 2019, it remains a story of growth - despite the headwinds from tariffs. Additionally, the three-year trend bears out that GDP is still expanding despite the latest GDPNow forecast from the Atlanta and New York Federal Reserve Board Banks (FRBs), which suggests 4Q2019 GDP growth will slow to less than 0.5 percent.
Employment: The three leading private industry measures - ADP (largest processor of payrolls for businesses in the U.S.), PayChex (primary entity monitoring small business labor), and LinkedIn's Workforce Reports - show private and small businesses adding employment. ADP's November 2019 report covering October data revealed: that companies of all sizes are still adding labor, the most coming from midsized companies with 50 to less than 500 employees; all industry sectors, except mining and manufacturing (as a result of the GM strike), are adding to payrolls; and a healthy 1.57 million jobs have been created year-to-date, an average of 157,000 jobs per month.
Where the government and BLS are unable to speak to wage growth, PayChex certainly can. The company's industry wage report through October 2019 showed every segment recognizing wage growth, ranging between 1.2 percent (education) and 5 percent (hospitality). The December 2019 BLS jobs report also reported year-over-year wage growth at 3.1 percent. All these factors - low unemployment, more job openings than unemployed persons, and wage growth in every industry segment - suggest a healthy job market heading into 2020 that will be conducive to CRE growth and continued capital investment across all property segments.Consumer Optimism and Retail Sales: The Commerce Department's report on October retail sales revealed a healthy rise. Excluding automobiles, gasoline, building materials, and food services, retail sales increased 0.3 percent, resulting in a year-over-year increase of more than 3.1 percent. This news is consistent with earnings from larger retailers like Walmart, which posted a 41 percent increase in online sales and a 3 percent increase in physical retail stores. With consumer spending driving two-thirds of the U.S. economy, this data indicates that no recession is in sight from the consumer perspective. The record $7.4 billion in sales from Black Friday through Cyber Monday in 2019 reinforces the view that consumer spending is in good health.
Small Business Activity and Optimism: The National Federation for Independent Businesses maintains the longest running comprehensive monthly survey on small business optimism. Readings above 100 are predictive of growth. Like consumers, small businesses are also bullish on the economy, with a November 2019 reading of 102.4.Corporate Earnings: These earnings often correlate with capex spending, hiring, wage growth, and demand for commercial real estate. Through mid-November 2019, 75 percent of the S&P 500 companies reported earnings and profits beat expectations. How are they doing it? Companies are remaking supply chains and finding efficiencies to offset margin erosion from tariffs. What's more, REITs - a harbinger of capital flow into CRE - have performed as well as, if not better, than corporate earnings. Strong performance by REITs is driving a recent wave of CRE portfolio transactions at year-end 2019.
Chapter 4: Commercial real estate Direction and Magnitude
Three CRE capital metrics that serve as the canaries in the coal mine for investing:
- FDIC-insured bank lending activity and income growth;
- CMBS loan performance and delinquency; and
- Commercial property price indices.
Performance measures for FDIC-insured banks (revenue growth and asset quality), CMBS permanent CRE loans (loan delinquency), and commercial property values continue to improve and achieve benchmarks not seen since before the Great Recession.
According to both Kroll Bond Rating Agency and Trepp, YTD 2019 CMBS volume in October surpassed the comparable figure for 2018. October's activity level of $12.4 billion brought YTD 2019 issuance to $70.2 billion, up 7.8 percent YOY. And the year-end pipeline for November and December was active with potential issuance, resulting in a 2019 figure that matches or surpasses 2018.
A more important measure than CMBS issuance, though, is delinquency. In Trepp's November CMBS Delinquencies report for the January through October 2019 period, the CMBS delinquency rate fell to another post-Great Recession low of just 2.47 percent. In comparison, the all-time high of 10.34 percent was registered in July 2012. On a property-type level, CMBS delinquency is down from a year ago across all but multifamily (up 0.19 percent). The slight increase in multifamily is relatively small and at a level below the overall delinquency rate of 2.47 percent. Additionally, Trepp's CMBS delinquency data is more broadly supported by the Mortgage Bankers Association's 3Q2019 Quarterly Commercial and Multifamily delinquency report, which shows just 45 basis points of delinquency in the banks and 4 to 6 basis points, respectively, in Freddie Mac and Fannie Mae multifamily loans.
Chapter 5: Capital Is Coming from All Directions
With no warning signals elsewhere, attention now shifts to the directional influences necessary to calculate the pace, magnitude, property type, and location variables for CRE capital vectors in 2020. In short, capital is coming from all directions - domestic and foreign, debt and equity. Why?
First, capital is attracted to the growing economy in the U.S. Second, it's a hunt-for-yield story, with the U.S. offering more on everything from interest rates on government bonds to dividends on stocks to cap rates and IRRs on commercial real estate. Not only does the country offer a 150- to 200-basis point government bond yield premium over the negative-yielding debt in Europe and Japan, but stock dividends, REIT returns, and property valuations (as indicated by cap rates of 4 to 6 percent) also offer an additional 200 to 400 basis points of yield over foreign market and asset alternatives. This yield differential is enough to mitigate capital concerns over tariffs and any potential slowing of the U.S. economy. Commercial real estate in the U.S. was the place to find an attractive yield in 2019, which is likely to continue in 2020.
Looking at the direction of capital flow, industrial and multifamily continue to be the property sectors in which foreign investors will increase their exposure. The Association of Foreign Investment in Real Estate 2019 International Investor Survey notes that approximately 80 percent of investors want to increase industrial exposure and 71 percent want to increase multifamily exposure. As to location, four of the top five global cities offering the most stable and secure real estate investment opportunities are in the U.S. - New York, Boston, Seattle, and San Francisco. Berlin was the only city outside the U.S. to make the top five ranking, beating perennial favorites London, Paris, Hong Kong, and Tokyo.
Chapter 6: Foreign Sources of Capital Investment
The U.S. commercial mortgage holdings of foreign-owned banks grew to $238.7 billion by midyear 2019, up 5.5 percent from a year earlier, according to Commercial Mortgage Alert. In the first six months of 2019, foreign banks' combined portfolios of U.S. commercial real estate loans increased by $8.8 billion, or 3.8 percent from year-end 2018. That amount exceeded the 2.7 percent growth rate for all of 2018. In other words, foreign banks are another CRE capital source that is increasing lending in the U.S. There are three likely reasons for this: global hunt-for-yield, foreign currency exchange volatility, and risk mitigation for fear of events like Brexit.
The figures from the top five countries suggest the CRE loan growth of foreign-owned institutions has outpaced CRE loan originations by domestic U.S. banks. Trepp data shows the 350 largest U.S. CRE lending banks held $1.66 trillion of commercial mortgages as of mid-2019, up just 1.3 percent from the same time last year. The key takeaway is that CRE investors need to understand that foreign banks are expanding debt capital into U.S. commercial real estate at a faster rate than the top 350 U.S. banks - another opportunity for CCIMs and other CRE pros.
Chapter 7: How to Navigate the Industry in 2020
It should be clear now that vectors are applicable to commercial real estate capital deployment. CRE professionals should pause and ask:
- What direction will capital flow into commercial real estate in 2020 (at both the property type and MSA/geographic levels)?
- What volume of both debt and equity capital will flow into CRE?
Triangulating the data from the sources cited in this report, the vectors pointing toward capital sources for commercial real estate focusing their efforts on five areas in 2020:
Searching for viable assets given a landscape that has a dearth of properties for sale in 2020. Finding assets and portfolios to list will intensify in 2020. Some relief may come from completion of new construction, but the market is clustered around primarily two property types - multifamily and industrial. Since it's late in the economic cycle, institutional and foreign debt and equity capital sources will not move away from these two property types
Ensuring that assets, while fully priced, are not over-priced. The New Year will continue to be a sellers' market - with a scarcity of assets for sale, low interest rates, and low cap rates. Having the investment and comprehensive market analysis skills to maximize net operating income - coupled with the ability to coax institutional investors out of their large-MSA bias that is driven by late-cycle liquidity anxiety - will be essential for success in 2020. Hone those discounted cash flow analysis skills to identify operating expense savings from areas like property tax appeals or rebidding property insurance, and deep-dive market analysis savvy that can differentiate submarkets, tenant, and lease-term trends, and assess the impact of new construction.
Understanding that while CRE debt capital is healthy today, risks are ahead. CRE concentration in domestic banks is back to pre-2009 financial crisis levels. With community banks healthy and able to lend more, now is the time to diversify your debt lending relationships in case a lender in your stable merges or pulls back due to its regulator's concerns over CRE concentration. Consider the community bank landscape as a diversification strategy from your large bank lenders. Bank regulators may think they've tackled “too big to fail,” but they have yet to say “too big to merge.”
Incorporating housing affordability as a cogent investment driver or deterrent in all markets. Just as Amazon left the West Coast for the East, Apple migrated to Texas and Norfolk Southern Railroad announced its headquarters will move to Atlanta. Housing affordability is as much a site selection and asset investment consideration as workforce availability and asset price.
Three letters: E-S-G. Environmental and social governance is permeating all aspects of CRE investing. Knowing how to factor in emerging local ordinances to enhance building efficiency in markets like New York and Washington, D.C., is critical to investment. A big unknown remains how capital will migrate from or toward intense ESG markets where capex is more of a known into less ESG-intense markets like Atlanta, Dallas, or other large non-coastal MSAs less fixated on the rising sea levels.
Chapter 8: Why CRE Investors Need a Plan B in 2020
There is no shortage of items keeping CRE investors awake at night. Some are uncontrollable; some can be mitigated to a certain degree with strategy; and others are avoidable if your vectors are properly calibrated. The uncontrollable factors that can't be mitigated unless one taps into money on the sidelines:
- The 2020 elections that may result in reversing the tax and economic policies currently in place;
- The Fed getting monetary policy wrong and the market losing confidence in the central bank; and
- Geopolitical items like Brexit (with more capital leaving Europe for the U.S.), and China trade.
Conversely, these items can be mitigated by altering capital and property mix or tracking construction activity:
As with any data, it's not about the numbers as much as the story behind them. The capital markets for commercial real estate in 2020 will remain strong, but it will take an added layer of sophistication on the part of the CRE practitioner to stand out in the crowd and enjoy success in the New Year.
- Elevated CRE concentration in the banks. It's time to diversify your lending relationships and capital mix with a higher ratio of equity.
- GSE reform gaining traction after 2020 elections and impact on multifamily. Simply rotate into other property type sectors like industrial, medical office, and student housing.
- Overbuilding risk prevalent today in self-storage with an emerging concern for industrial. Monitor the ratio of new construction activity as a ratio of total existing inventory and diversify out of those markets where the ratio is above 2.5 to 3.5 percent of existing inventory.
- Capital migration from high-tax states creating a fiscal crisis for preferred foreign investment markets like New York, San Francisco, and Chicago. Consider heading south to low-tax, low-cost states like Florida, Texas, the Carolinas, Utah, Arizona, and re-emerging parts of the Midwest like Indiana, Ohio, and Michigan.