CCIM Feature

Yield Ahead

Beware of potential speed bumps in 2019.

While the U.S. economy picked up steam in 2018 thanks to strong confidence from both consumers and businesses, commercial real estate professionals may need to brace for some speed bumps ahead in 2019.

Heading into the fourth quarter of 2018, consumer confidence remained elevated due to high levels of employment and business expansion. In fact, the U.S. posted a record high number of job openings in October, with more jobs available than unemployed people in the workforce, according to Job Openings and Labor Turnover Survey (JOLTS) employment data. Another key indicator, the National Federation of Independent Businesses Small Business Optimism Index, remains near record highs at 107.9 in September 2018 after hitting a record high of 108.8 in August.

Although tax reform certainly has been a positive influence on sentiment, the full impact of the 2017 Tax Cuts and Jobs Act won't come until 2019. In 2018, much of what has driven the economy has been optimism spurred by regulatory relief under the Trump administration. The biggest problem facing businesses is finding people to fill jobs, including both skilled labor and labor at the low end of the pay scale.

The early reading of third quarter 2018 gross domestic product growth released at the end of October came in at 3.5 percent, which shows continued strong momentum in the economy led by consumer spending even as business investment moved to the sidelines to wait out results of the November elections. Meanwhile, early earnings releases for 3Q2018 from manufacturing and transportation companies have been telegraphing that materials costs are rising and margins are under pressure, which will likely suppress earnings growth in 2019.

Yet the momentum in this economy faces some headwinds that will, at a minimum, slow growth. Worst-case scenario? Headwinds could tip the economy into recession in late 2019 or the first half 2020. Looming challenges are the lingering effects from the November midterm elections, rising interest rates, and new lease accounting rules. Psychology plays a big role in propelling economic growth, and it remains to be seen whether a new Democratic majority in the House of Representatives will lead to more gridlock in Washington and have a negative impact on business and consumer sentiment.

Industrial Holds Onto Strong Lead

The industrial sector has emerged as the leader among the major property types with still strong improvement in rents and rising values, which continues to spur development and investment activity. For example, the Green Street Commercial Property Price Index for September shows that industrial has had the highest price appreciation of all property types (except for manufactured homes) over the past 12 months, with an increase of 11 percent from September 2017 to September 2018.

That momentum is likely to continue into 2019. Industrial is the new retail, and it is surging along with the shift to e-commerce sales and companies that are reconfiguring supply chains. More specifically, it is the logistics sector - bulk warehouse and distribution and fulfillment centers - that are benefiting the most from that strong demand. Industrial also is a perfect example of how it may be time to start merging - or perhaps relabeling - some traditional property types, such as retail and industrial to logistics real estate. Amazon's move into the grocery sector with its Whole Foods acquisition is an example of how the two worlds of e-commerce logistics and retail now are colliding.

Another tailwind for industrial is the new United States-Mexico-Canada Agreement (USMCA), an innovative trade agreement that is a win-win-win for all three countries. It specifies that 75 percent of a product must be either manufactured or assembled in North America. That brings the U.S., Canada, and Mexico into a significant and competitive trading block with China and Asia. USMCA also could bring both China and Europe back to the negotiating table and potentially put an end to the trade war with China that has been raising costs on both imports and exports in 2018.

The agreement also stipulates that a particular good must be assembled in a high-wage market zone, which is defined as a market where the average wage is at least $16 per hour. This requirement is powerful because it puts the U.S. and Canada on a more level playing field with Mexico in terms of wage rates, and it also will help spur more middle-class growth in Mexico. 


Apartments Benefit From Housing Shortage

Barriers to entry in the homeownership market are helping to drive demand for rental properties. Despite concerns about overbuilding, multifamily continues to perform very well. Rents continue to growth at 2 to 4 percent. Meanwhile, occupancies are holding steady in the 94 to 96 percent range, with some markets reporting even higher occupancy levels.

Homebuyers, including first-time homeowners, are finding a shortage of affordable housing options in the for-sale market for homes under $300,000. Builders simply can't make money at that lower price point because margins have been stretched thin due to higher construction and labor costs. Normally at this stage in the recovery, builders would be on pace to deliver between 1.3 to 1.4 million new homes annually. However, the current number is about 1.15 million. What's missing are those homes under $300,000.

Yet the affordable housing crisis is pushing some exciting out-of-the-box thinking. The country is on the verge of tremendous innovation in affordable housing development, with new ideas and business models that will continue to emerge in 2019. Atlanta, for example, has changed its zoning to allow for tiny-home subdivisions. Builders also are creating entire subdivisions of single-family rental properties. The investment community has shown that the business model for single-family rentals can be very profitable, and capital markets are very intrigued.

Retail Continues to Reinvent Itself

One story that will continue to unfold in 2019 is store closings. In October, Sears announced that it intended to close 142 stores by the end of 2018 as part of its bankruptcy filing. Mall owners will be dealing with those new vacancies well into 2019. In addition, we'll see the continued demise of traditional retailers, with more store closures and bankruptcy announcements in the coming year. In 2018, an estimated 8,000 stores closed - that could grow to 9,000 in 2019. However, that does not indicate a retail apocalypse or that retail is dead. The retail sector simply is continuing to reinvent itself.

Related to those store closings is the adaptive reuse and repurposing of vacant, underutilized, or obsolete properties. CCIM Institute and the Center for Real Estate at the University of Alabama's Culverhouse College of Business have partnered to establish a database to track adaptive reuse projects across the country. Currently, about half of the projects in the database are retail. Across all property types, adaptive reuse accounts for about 1 to 2 percent of all new commercial activity, and that could double to 4 to 5 percent over the next three to five years.

Grocery retail is headed down the same path as mall department stores as consumer behavior continues to move toward online or e-delivery platforms. Not only will grocery store space be changing, but changes in this sector also will impact the long-term nature of their leases. So, a double whammy could be ahead for grocery-anchored retail centers.

In addition, retailers are taking a page from Amazon, and the marketplace will see new partnerships formed that will disrupt traditional sales channels. Some examples include Target's acquisition of Shipt, and Advanced Auto Parts new partnership with Walmart, where Advanced Auto merchandise will now be available on Walmart.com and sold in Walmart Auto Care Centers. We're likely to see more of these types of alliances announced in 2019 as e-commerce continues to expand into every type of product and good, including auto parts, autos, groceries, and pharmacy.

The 2019 Outlook: Caution Ahead

How long will this near-record economic growth cycle last? If the country makes it through first quarter without a recession, it will be the first time since 1857 (yes, 1857!) that the country has gone longer than 10 years without an economic recession. History is against us, and the reality is that several forces are converging that could push the country into a recession by the end of 2019 or 2020.

 


Aside from the political discord dividing the country, the two biggest potential disruptors for 2019 will be changes to lease accounting rules and moves by the Federal Reserve to raise interest rates. One concern is that the Fed may be too eager to get the country out of quantitative easing. Yet the tentacles of unwinding quantitative easing are far reaching, with some of the ripple effects being currency crises that already have emerged in Italy, Turkey, and Argentina.

Rising interest rates also have a costly impact on the U.S. deficit in terms of raising the amount of net interest that the country pays on its national debt. The budget item experiencing the most growth in the federal budget is net interest on national debt. It is up nearly 20 percent year-over-year due to another $1 trillion in deficit spending following four Fed rate hikes, according to the Congressional Budget Office.

In addition, the impact from lease accounting rules could be one of the biggest disruptions to commercial real estate since the 1986 tax code change that triggered the savings and loan crisis. Companies will be penalized for carrying long-term leases, which may discourage companies from committing to them. For example, new rules could be especially disruptive to the triple-net lease market that is driven by long-term leases from tenants such as drug stores, dollar stores, and restaurants. The market will adapt to more short-term leases, but in the meantime, it could create some disruption over the next two to three years.

 

Bright Spots Ahead

Now for some good news. Several factors could help to prolong this near-record economic growth cycle. The Tax Cut and Jobs Act could give the economy an added lift this year. However, the reality is that much of 2018 was spent analyzing the new tax laws for 2018 tax returns, meaning that the actual savings will begin trickling into the economy in 2019. For corporations, capital planning was done in first half 2018 after the tax bill was approved, with actual capital deployment that will begin in 2019.

The Tax Cut and Jobs Act also created opportunity zones that offer a tax incentive for investors to defer and reduce capital gains taxes by investing gains from the sale of assets into opportunity zone funds. These funds then deploy capital in designated areas, which for the most part are qualifying low-income neighborhoods. Combined, the tax act and opportunity zones could stimulate the economy and create a positive impact for commercial real estate professionals in 2019. In October, the Treasury Department issued some clarifying, encouraging rules regarding opportunity zones, with more to come. But all seems to be heading in a direction that could make opportunity zones the most impactful real estate tax benefit in decades.

Going forward, one of the best crystal ball techniques you can do on your own is to monitor the quarterly earnings for companies key to your local economy. These quarterly earnings reports will tell you much more than government data about what's ahead for your region and why.

Read CCIM Institute's 4Q2018 Commercial Real Estate Insights report, "Commercial Real Estate Finance Disruption: Déjà Vu or Something New?," for a deep dive into the future of commercial real estate finance. 

Coworking Dominates Office Leasing

Densification is a hot topic of late in the office sector, as companies tried to squeeze more workers into the same or even smaller spaces. Densification now is giving way to coworking. Yes, coworking offers some cool and trendy space options with perks for tenants ranging from gourmet coffee and cookies to cold beer on tap. But a bigger driver for tenants is the new lease accounting rules that go into effect at the end of 2019. Companies now will be required to report all lease obligations as a liability on their balance sheets. Potentially, the long-term leases of 10, 15, or 20 years that were the norm in the past could disappear as they now can negatively impact company balance sheets and credit ratings.

Companies are looking at third-party coworking spaces as an alternative to those lease liabilities. That shift is one of several factors fueling explosive growth in the coworking sector from firms such as WeWork and Regus, along with landlords that now are offering coworking space directly within their properties. Coworking has the potential to be a big disruptor for the office sector. For example, WeWork is now one of the top tenants in several of the largest markets in the country, and the firm ranks as the largest tenant in New York City and Atlanta.

With coworking, companies don’t have to report these agreements on their balance sheets. They don’t have any capital tied up in the furniture or equipment, and they can be more nimble in their space needs. For commercial real estate professionals, coworking means a lot of change is coming to the office sector, and brokers and lenders have to rethink how leases work and how to value and underwrite office assets in this new paradigm.

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K.C. Conway, MAI, CRE

K.C. Conway, MAI, CRE, is CCIM Institute's chief economist and director of research and corporate engagement at the Alabama Center for Real Estate, housed in the Culverhouse College of Business at the University of Alabama. 

CIRE January/February 2019 Cover

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