“You miss 100 percent of the shots you never take, and if you think it’s expensive to hire a professional to do the job, wait until you hire an amateur “ AND “The major fortunes in America have been made in land.”- John D. Rockefeller
By Beth Mattson-Teig | July.August.17
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.”
Slowing Momentum
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.
Potential Pitfalls
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.
“You miss 100 percent of the shots you never take, and if you think it’s expensive to hire a professional to do the job, wait until you hire an amateur “ AND “The major fortunes in America have been made in land.”- John D. Rockefeller
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