Many sports analogies are being thrown out to describe how close the U.S. commercial real estate market is to its cyclical peak. Regardless of whether fans are keeping score based on quarters, innings, or overtime, time is still left on the clock.
It is no wonder that the maturity of the market cycle is garnering plenty of attention. The U.S. commercial real estate market is now eight years into its current economic expansion, which is lengthy by historical standards.
“I don't see a lot of risks to the cycle in 2017,” says Ryan Severino, chief economist at JLL in the New York City metro area. “I don't even see all that much in 2018. I think we have at least a couple of years before we start to have that question about is the clock ticking or not."
Yet there are signs that the momentum is slowing. “The commercial real estate market right now is clearly late in the cycle overall, but that is something that needs to be dug deeper into both by market and asset type,” adds Spencer Levy, Americas Head of Research for CBRE.
Specifically, softening is occurring in areas, such as central business district office rents, CBD multifamily rents, and high street retail. Weakness also is appearing in peripheral B and C malls and power centers. At the same time, other sectors are still quite strong, such as industrial, suburban office, and suburban multifamily, and Class B and Class C multifamily, according to Levy.
Market cycles also vary widely based on geography, with some metros that have raced toward the peak, while others have proceeded at a slow pace and have greater upside potential ahead. “There is no such thing as a national real estate market. Every market and economy is local in nature,” says Ted C. Jones, Ph.D., chief economist and senior vice president at Stewart Title Guaranty Co. in Houston.
For example, Houston has not created any net new jobs during the past two years. However, the market added more than 20,000 new apartment units last year. “We are seeing a pretty good erosion in Class A apartment rents,” Jones says.
However, Jones remains bullish on the economy overall. Most economists are forecasting favorable economic and job growth, which bodes well for the broader commercial real estate market.
Gross domestic product growth did decline to 1.6 percent in 2016, but it is expected to pick up more speed with a rise to 2.3 percent in 2017 and 2.6 percent in 2018 before pulling back to 2 percent in 2019, according to the latest ULI Real Estate Consensus Forecast released in April 2017.
The ULI Forecast for employment anticipates good, but lower, levels of growth ahead. The U.S. added 2.24 million jobs in 2016, and those numbers are expected to decline to 2.20 million this year, followed by another 1.90 million in 2018, and 1.55 million jobs in 2019.
“We think that the jobs situation is going to improve late this year and probably early next year - if the new Trump administration is able to get through some of its fiscal stimulus policies,” Levy says. “If we can't get major tax reform done, I think we are at risk of a much more muted growth profile.”
Stealing the Show
Industrial has been on an incredible run over the last several years, thanks in large part to the rise of e-commerce. It was the No. 1 performing asset class on total return basis on a one- and five-year basis, Levy notes.
The risk for industrial is excess supply. “We don't see that happening just yet, because it is hard to find sites to develop in many of these locations, which are particularly strong,” Levy says. “The industrial cycle may last longer than perhaps it will for office and multifamily.”
Along with positive growth from manufacturing, e-commerce will help to keep demand for space strong and occupancies well above the historical average. The sector, however, may see slower growth ahead.
The ULI Forecast predicts a 20-basis-point decline in vacancy levels to 8 percent by year-end, no change in 2018, and a slight move higher to 8.4 percent in 2019. Sizzling rent growth also will cool from the high of 6.6 percent recorded last year to 4.6 percent this year, 3.8 percent in 2018, and 3 percent in 2019.
Battling New Supply
Multifamily jumped out to an early lead in the recovery, and many experts have viewed this sector as racing toward the peak for some time. Despite that already long run, some structural changes are at play that could help to prolong the current cycle, according to Severino.
Changing demographics and more people who are choosing to rent versus own have provided a tailwind. In addition, the median age for the first-time homebuyer in the U.S. is 31. Most of the millennials are 24 to 26, which puts them a good five years away from buying a home and moving out of rental housing, he adds.
“The biggest challenge apartments face in most markets is excess supply,” says Kenneth Riggs Jr., CCIM, CRE, MAI, president of Situs RERC in Chicago, a real estate valuation advisory firm.
New construction is putting more downward pressure on rents, especially in Class A properties. According to Reis, construction in the top 82 markets studied surpassed 200,000 units in both 2015 and 2016.
“However, while performance will be a lot lower than it has been, it will still be a favored asset class because of the income characteristics and the diversity of income streams,” Riggs says. While the primary markets may have reached their peaks, there is still room for expansion in secondary markets, such as Austin, Texas; Nashville, Tenn.; and Charlotte, N.C., he adds.
Vacancy rates likely bottomed out at 4.6 percent in 2015 and are now inching higher due to the heavy load of new supply. Vacancies are expected to tick higher to reach 5.2 percent by year-end, and increase slightly to 5.3 percent in 2018, and 5.4 percent in 2019, according to the ULI Forecast.
Multifamily rental rate growth slowed significantly in 2016, growing just 0.2 percent after six straight years of growth over 3 percent. Rental rate growth is expected to increase to 2 percent this year and stay flat at 2 percent in both 2018 and 2019.
Tepid Demand for Office
Belt-tightening in the wake of the recession and a rise in alternative workplace strategies have taken a toll on the demand for more office space. Net absorption was 4.9 million square feet in the first quarter, down from an average net absorption of 9.4 msf per quarter in 2016, according to Reis.
Office is a property sector where a big gap in performance exists between the top and bottom markets. Downtown office space is doing well, while suburban office is still sputtering along in the recovery phase in most U.S. cities, according to Jones.
Some metros have been “just crushing it,” Severino agrees. Standouts include tech-oriented markets such as San Francisco and San Jose, Calif.
“Technology has clearly been the star performer when it comes to office employment growth during the last five, six, or seven years,” Severino says.
According to JLL, tech firms accounted for a sizable share of the overall leasing volume in Q1 at 24.2 percent followed by the financial sector at 14.2 percent. While the office sector has had its challenges during this cycle, rent growth has accelerated in 2015, 2016, and 2017, according to Severino.
Office vacancies are expected to improve about 30 basis points this year to 12.6 percent and then remain relatively flat during 2018 and 2019, according to the ULI Forecast. Annual rent growth will remain modest at between 2 and 2.5 percent.
The Reckoning for Retail
E-commerce has been a major disrupter for the retail sector. Despite strong consumer spending, a fresh wave of store closings and retailer bankruptcies have occurred during the past 12 months, with more ahead in the second half of the year.
“We are over-retailed, and we have some concepts that are obsolete,” Jones says. The land underneath stores, such as Sears and J. C. Penney - and arguably even Macy's - is more valuable without those stand-alone stores, he adds.
However, some bright spots exist in the sector, along with a bigger gap that is emerging between winners and losers. Many malls are adapting to the changing dynamics by introducing new anchors, such as restaurants and more entertainment.
Outlets and value-priced retail concepts, such as T.J. Maxx and Nordstrom Rack, are outperforming their department store rivals. Retailers also are restructuring and trying to fine-tune strategies that combine both online and brick-and-mortar sales, along with a supply chain that allows them to deliver goods to customers fast and cost-effectively.
“No. 1, I think a lot of the negative chatter about retail is overblown,” Levy says. “And No. 2, this talk creates tremendous opportunities for people going into the space now, because most institutional-grade real estate is performing very well.”
New construction has remained limited, which has helped absorb the excess space still in the market. Since peaking at 12.9 percent in 2011, retail vacancies have been steadily declining with a forecast for rates to reach 10.1 percent by year-end.
Vacancies are expected to remain relatively flat in 2018 and 2019, while annual rent growth will continue to hover between 2 and 2.5 percent through 2019, according to the ULI Forecast.
Many factors have contributed to the prolonged real estate cycle. The real estate market has been taking its cues from the slow, steady pace of growth in the economy.
Regulatory pressures also have kept lending and development in check. “The economy looks favorable and is moving forward on a measured pace and capital markets have been disciplined,” Riggs says.
Interest rates are one of the wild cards ahead. “We know that the Federal Reserve wants to raise short-term rates, but it will do it at a very careful pace and try not to be disruptive to the economy,” Riggs says. But outside of the Federal Reserve's control is the 10-year Treasury note, which has been lower for a longer period than anyone has expected, he says.
Another wild card is the new Trump administration and the success - or failure - it has in moving key policies forward, which economists are watching closely. Policies such as tax reform, reduced regulation, and infrastructure spending could boost economic growth.
The likelihood of that happening, however, is very difficult to handicap at this point, especially after the Trump administration did not succeed in its initial bid to pass healthcare reform early in the year, according to Severino.
“As long as we don't get some kind of idiosyncratic shock to the economy or the economy ends up disappointing in some major way, I still think there is room to run in this cycle before we have to start worrying about things turning against s,” Severino adds.
Changing Capital Costs
by Beth Mattson-Teig
The Federal Reserve has made its intentions clear as it plans to raise short-term borrowing rates. The question remains as to whether it will stay that course in the second half of the year, and whether long-term rates will follow suit.
At this stage of the cycle, it seems almost inevitable that the extended period of historically low interest rates has finally run its course.
“Our view, like many, is that long-term rates should move moderately higher this year to between 2.5 and 3 percent and then press over 3 percent as we head into 2018,” says Kenneth Riggs Jr., CCIM, CRE, MAI, president of Situs RERC in Chicago, a real estate valuation advisory firm.
Yet whether those higher rates materialize remains to be seen. “I have been predicting a 100-basis-point increase in the 10-year Treasury for the past eight years, and I have been wrong eight years in a row — as have most economists on the planet,” says Spencer
Levy, Americas Head of Research for CBRE in the New York City metro area.
After the presidential election, the 10-year Treasury note climbed to a high of about 2.65 percent. It has since dropped lower and was hovering at about 2.28 percent as of late April.
The inability of the Trump administration, at least in its first attempt, to pass healthcare reform was damaging to perceptions of U.S. growth expectations. That has manifested itself, not only in people being less optimistic, but also in a drop in the 10-year Treasury, Levy notes.
Uncertainty on interest rates and the implications for commercial real estate values and pricing has created a drag on investment sales. Transaction activity across all property types slowed in Q1 2017 to $75.7 billion, which was down 35 percent compared to the $116 billion recorded
during the same period a year ago and decreased 46 percent compared to the $139 billion in Q1 2015, according to Real Capital Analytics.
Given the late stage of the cycle, investors are more selective and cautious, according to Riggs. “There are still buyers and sellers. However, there are not as many buyers as there were 12 months ago, and we see that in the number of transactions that
are being completed,” he says.
At the same time, a significant amount of investment capital in the market needs to be deployed. In addition, the cost of capital remains historically low for borrowers. A tremendous amount of capital is out there from a diverse variety of sources.
The one exception is bank construction lending due to regulatory pressure, Levy says. “Access to capital for everything except speculative construction has never been stronger,” he adds.