For those keeping score during this third-longest economic recovery since World War II, the bulls continue to have a commanding lead over the bears. Despite volatility in the stock market and political uncertainty, economic growth is expected to remain steady through midyear, with momentum that likely will carry on well into the latter half of 2018.
Literally every economic measure, whether it is auto sales, gross domestic product growth, jobs numbers, or manufacturing data, was off the charts favorable for first quarter 2018. We finally have returned to all aspects of a 3 percent economy. Government's initial estimates of first quarter 2018 GDP of more than 2.3 percent supports my forecast that it will turn out to be the best Q1 GDP in a decade. Backing up this outlook are strong Q1 corporate earnings. Corporations are knocking the cover off the ball in terms of earnings and growth - from disruptive technologies, like Amazon and Facebook, to equipment manufacturing and transportation, to old-school industries, such as Caterpillar and Union Pacific Railroad.
Some of the good forward-looking indicators of what lies ahead include jobs data, specifically the new monthly LinkedIn Workforce report that highlights skills-gaps by metropolitan statistical area as opposed to the flawed monthly Bureau of Labor Statistics jobs report. Other good measures include watching what small businesses and homebuilders are telegraphing. For example, the NFIB Small Business Economic Trends Index shows that small businesses are optimistic in the wake of tax reform and regulatory relief. The index was under 100 for four straight years until President Donald Trump was elected, and has remained in a bullish 103-107 range through 1H2018.
So, what could go wrong? Although everything appears copasetic and like the Lego movie (Everything is Awesome), some bearish concerns are in the market. Positive momentum could be subject to disruption due to uncertainty surrounding potential Black Swan events that include:
- Threatened tariffs and a resulting trade war with Asia and Europe;
- November midterm Congressional elections;
- A volatile Mideast with unresolved nuclear and chemical weapons threats from Syria and Iran; and
- Federal monetary policy (interest rate hikes and selling down its balance sheet and extracting liquidity) along with market impacts from the rise in the yield for the 10-year Treasury Bond.
If Democrats regain control of the House, Senate, or both, in the upcoming midterm elections, they could undo the tax bill and undo much of the regulatory relief occurring under the Trump administration. Likewise, the economic stimulus that we are starting to see kick in could be undone, which is why we are seeing a reintroduction of stock market volatility. Any or all of these Black Swan events quickly could reverse small business and consumer optimism and send us back to a sub-2 percent economy.
Rising Interest Rate Environment
We have been waiting for the economy to be strong enough to sustain wage and price growth, and the consequence of that is interest rates moving higher. The big focus for commercial real estate in the near term will be how to function in a rising interest rate environment.
Interest rates have been incredibly low for the past decade. People have grown so accustomed to almost free money and low interest rates that they may not know how to function in a rising interest rate environment. Investors in commercial real estate need to adjust to those higher rates. The 10-year Treasury already has started moving higher. At the end of April, the 10-year Treasury hit 3 percent for the first time in more than four years.
The Federal Reserve raised the short-term bank lending rate 25 basis points in February (its sixth increase in two years), and I expect the Fed to raise interest rates three more times this year. The next 25-basis-point increase likely will come in the June meeting, followed by additional increases in September and December, for a total of 100 basis points, or a full 1 percent increase this year.
In commercial real estate, cap rates have compressed, and values have gone up due to historically low interest rates. That gig is up. Now the way property values are going to go up is through increasing net operating income. Commercial real estate brokers and CCIMs will have to be much more tuned into NOI, lease maturities, and the potential to raise rents, to see if a particular property or market can absorb higher interest rates without the property declining in value as cap rates rise in response to higher interest rates.
Industrial Engine Remains Strong
Despite a potential trade war, the bulls are continuing to run in the industrial sector. E-commerce is fueling unprecedented demand for distribution and warehouse space handling virtually everything that people consume, from produce to paper products. All are being bought online in bigger and bigger quantities. In the U.S., e-commerce sales now account for about 9.1 percent of total retail sales. And that percentage is much higher - upwards of 20 percent - when excluding sales from autos, gasoline, restaurant, and food categories.
The next two big disruptors in online sales that will further benefit industrial are grocery and autos. Giants such as Amazon and Walmart are putting more competitive pressure on their peers as they continue to improve on e-commerce platforms and rapid delivery. Auto sales also are shifting to online sales, replacing the traditional model of showrooms and acres of parking on prime real estate. Today, consumers don't walk acres of inventory in search of a new car; rather they click their way through online inventory stored in warehouses ready to be instantly financed/purchased and delivered overnight in much the same way as apparel is consumed today.
A potential trade war would have a dampening effect on industrial, with tariffs that make imports and exports more expensive. Less shipping activity translates into reduced demand for warehouse space. However, trade wars are relatively short-lived, because they are not effective. A trade war could disrupt the market for 12 to 18 months, but no one is interested in creating a prolonged, expensive trade war.
Retail Faces Challenges and Opportunities
Retail disruption is driving widespread change throughout retail properties, but it is important to note that the transformation within the sector is not a retail apocalypse. A recent research study conducted by the National Retail Federation and the IHL Group looked at the top 1,000 brands and found that for every group that was closing stores, another 2.7 were opening stores. Those retailers that are opening new stores span a variety of categories that are more experiential in nature than goods selling. That is an important statistic to realize; despite the challenges in the market, there are still opportunities for growth and expansion.
The PGA Tour Superstore is one example of a retailer that is dialed in on the recipe for success in today's market. The formula that works is one part merchandise and selling stuff to nine parts experience and service. When customers go into a PGA store, they can check with a golf pro for advice, get clubs repaired, customize golf balls, or use the indoor driving range. The retailers that are going to expand and be successful are those that can blend experience and service with selling merchandise. Another retail recipe that works is retail integrated with mixed-use development.
Specific to trends in the grocery sector, Amazon is poised to be a big disruptor, with changes ahead that could happen relatively quickly. It is important for those who invest or lend in retail to understand that shift. People used to look at grocery-anchored centers as the safe haven for retail, but they are potentially just as vulnerable as department stores and big-box retailers as more grocery sales shift online. Today, it is estimated that more than half of what we purchase at a grocery store can be purchased on-line and delivered to our home without a delivery charge at prices equal to or less than a grocery store.
Tech Slows Demand for Office
Densification has been the big trend to watch in office, as companies pack more people into the same amount of space. The resulting downsizing and consolidation slowed the office recovery, because companies needed less space to accommodate growth. The new trend going forward is a new term I refer to as “AI-cation” - the application of artificial intelligence to every industry and property type. The rise of AI - artificial intelligence and machine learning - means that companies are not just getting rid of filing cabinets as they shift to digital storage and more telecommuting; they are eliminating positions altogether.
The banking and financial services industry, for example, is slashing staffing and closing branch locations as more banking transactions take place online. Some forecasts predict that up to 50 percent of all bank branch locations could close within the next five years. Other industries, such as financial services, accounting, and engineering, also are adopting new technologies that bring increased automation to jobs that had been done manually in the past.
The result is a bearish outlook on office, because AI-cation is going to result in lost white-collar jobs and less demand for office space. The concern for office is that net demand for office space will grow very slowly.
Demand Remains High for Apartments
The apartment sector is delivering mixed signals, with risk of oversupply occurring in luxury apartments, while huge demand still exists for affordable and moderately priced housing. Going forward, developers will have to take a close look at the job growth occurring in local markets, as well as the existing multifamily stock in terms of the type, quality, and price point of rental rates.
Job growth is the fundamental driver for every property type, and it is especially important for apartments. The standard ratio of 5:1 - every five jobs created support the absorption of one more apartment in the market - has been an accurate indicator since the 1950s. Recently, that ratio has been running almost 7:1 in terms of jobs created compared to new multifamily construction. Generally speaking, that indicates that developers are not overbuilding multifamily. However, there is risk of oversupply in luxury apartments due to a high volume of construction at the top end of the market, which is a problem that has been compounded by rising land and construction costs.
When considering the outlook for the second half of 2018, it is likely that huge swings in stock market indexes will linger along with the political uncertainty. But that volatility can be good for commercial real estate. In this type of environment, capital tends to favor tangible and less volatile assets with stable cash flows, like commercial real estate. That rotation is what we are evidencing, with strong demand for commercial real estate. We once again need to ask the proverbial question: “So, what could go wrong?” Cleary, the market does face challenges with potential Black Swan events, as well as adapting to an environment with higher interest rates and higher cap rates.
One of the biggest opportunities ahead, and also the most complex challenge, will be the adaptive reuse and repurposing of properties across every property type. There will be a bigger focus on repositioning obsolete and under- utilized properties, partly because of the desire to recycle existing assets, as well as rising land and construction costs that will drive more value-add and opportunistic redevelopment. Often those complex projects require a deeper skillset in dealing with everything from underwriting to changing zoning.
Big Data Poised
to Shake Up CRE Financing
by K.C. Conway, MAI, CRE
Capital markets are beginning to rethink how they are using
big data and artificial intelligence to better analyze, underwrite, and
mitigate risk. The variables that go into underwriting and valuation are on the
verge of radical change, which is creating huge implications for the commercial
real estate industry.
Employment data is one of the key indicators for gauging
demand for all types of real estate. Traditionally, investors have used Bureau
of Labor Statistics numbers for underwriting. However, that government data has
earned a reputation for being horribly
inaccurate. In the era of big data and growing transparency, commercial
real estate professionals are finding new and better sources of jobs data.
One new source is the LinkedIn Workforce Report. The
LinkedIn network now includes 140
million working professionals that continually are updating job status and
changes. LinkedIn is able to capture that data, and about a year ago started
generating its own Workforce Report with monthly job changes that are divided
into 50,000 skill classes. It is incredibly rich data that companies can use in
their underwriting models.
Commercial real estate professionals also are bringing in
additional sources of big data to more accurately underwrite new investments and
financing. For example, underwriting a property anchored by a department store
such as a Sears or Macy’s used
to rely primarily on credit rating and the rent that retailer was paying.
Underwriting now is considering new data sources that use cell phone data to
track foot traffic to those stores. If data shows that there is zero foot
traffic near Sears, then they can document that Sears as an anchor has no value
and the shop space surrounding Sears also has less rent value.
Another change ahead relates to how real estate is
classified and compared. For example, the characteristics and performance of
urban adaptive use retail in a mixed-use project are very different as compared
to a suburban shopping mall in terms of rents, demand, and even average size of
the retailers. What is needed, and what is likely looming around the corner, is
a reclassification of real estate from
size to type of use or location.
The application of big data to better understand demand,
use, and traffic patterns for commercial real estate has the potential to turn
underwriting in the finance world absolutely upside down. We have to rethink
all of our variable inputs into investment analysis, because many of the old
ones are obsolete and don’t tell
us what we want to know. What the industry will see going forward is that big
data will be used to mitigate risk and also be incorporated into acquisition
and financing underwriting, valuation, and pricing of debt.