Consider Market Cycles When Reassessing Portfolio Strategies
The recent economic slowdown, while unevenly affecting various U.S. regions, has led to a diminished gross domestic product, corporate restructuring, and a loss in wealth due to the stock market's decline. These changes have pushed the commercial real estate market into contraction, and assessing the fallout may reveal unique opportunities for commercial real estate owners and investors.
Virtually all product types are experiencing diminished growth in demand. This clarion call to owners, asset managers, and property managers should prompt them to reassess portfolio and property strategies. And as the market moves through the four real estate cycles — expansion, contraction, recession, and recovery — property owners and investors also must re-evaluate their actions.
In the current contraction phase, intensive proactive management can continue to enhance cash flows and value growth. Further, in a declining interest-rate environment, refinancing strategies can benefit cash-on-cash returns. To remain profitable, property owners carefully must consider the current status of commercial real estate in relation to overall market cycles and make changes accordingly.
The current contraction is not anticipated to mirror the real estate recession of the 1990s. Moderate supply increases during the last few years, coupled with disciplined underwriting standards by lenders, have resulted in minimal oversupply in most geographic and property markets.
The dot-com fallout, corporate layoffs, and reduced new-business formation have diminished the demand for office properties. From a supply perspective, markets generally are not overbuilt, yet significant increases in vacancies and decreases in rents are occurring. At this time, judging how deep the contraction will be is difficult because of insufficient data on corporate sublease space. However, indicators suggest that the amount of office square footage that will move into a contraction phase (with lower rents and higher vacancies) will increase dramatically during the next two years. Accordingly, the office market is poised at the beginning of a potentially difficult phase.
The retail market faces challenges on many fronts: online retailers, major anchor store closings, and myriad strategies implemented to deal with less demand, such as more-cooperative advertising and using kiosks to increase revenue. This property type will be confronting significant contraction in the next two years, and, accordingly, minimal new construction is anticipated.
While still robust, the industrial market will experience reduced demand in the coming two years due to less movement of goods throughout the economy. This mirrors the contraction found in the office sector. However, unless the U.S. economy slips into a full-fledged recession, the impact of less demand for industrial space should not be as dramatic as that experienced in the office sector, since most industrial space is leased long-term and has less lease rollover.
This year has been difficult for the hospitality market, which suffered reductions in both business and leisure travel. The strongest markets in the country, such as New York and Los Angeles, have experienced not only lower occupancies but also reduced average daily rates. Fortunately, significant new construction has not occurred, and, accordingly, hotel occupancies and rates are expected to rebound in 2002 if the economy makes a soft landing.
The multifamily market is the bright spot in the commercial real estate industry. Growth in household formation, nonmarried households, and migration to the United States has increased demand for multifamily product. Coupled with limited urban infill development opportunities, these factors should position the multifamily market for strong occupancies and rising rental rates in the next two years.
Now that the U.S. real estate industry has shifted from expansion into contraction, experts predict that movement through the four phases may be less pronounced. In fact, if a soft economic landing occurs, the country and the commercial real estate industry may avoid recession altogether and transition straight into recovery.
This unique movement presents interesting challenges for property owners and purchasers. While forecast demand growth is less, it is not negative growth. Also, slower growth does not necessarily drive property pricing down. Growth in income can offset higher capitalization rates required by buyers, and, as such, the commercial real estate industry may experience less value increases but not necessarily value declines.
Most importantly, the purchase or management of commercial real estate assets in a contraction phase must be proactive. Owners and investors must evaluate their properties' susceptibility to diminished demand by closely managing tenant leases; monitoring expenses, particularly capital expenditures; assessing the impact of new supply coming into the marketplace; and considering their properties' redeployment and redevelopment opportunities. In this phase of the cycle, the flip side of adversity may be opportunity.