By: George Ratiu, Managing Director of Housing & Commercial Research, NAR
Economic expansion turns nine years old
We find ourselves in the ninth year of economic expansion, with most indices pointing in an upward direction. According to the Expectations & Market Realities in Real Estate 2018 report, published by Deloitte, the National Association of REALTORS® and Situs RERC, most global economies toiled under sunnier skies over the past year, with about 75 percent of countries experiencing gains.
In the U.S., gross domestic product has been expanding steadily, boosted by a combination of higher consumer spending, rising business investments, and solid export activity. For consumers, the pace of job creation and wage growth spurred increased optimism, which led to higher spending. Employers added 2.2 million new jobs to payrolls during 2017, bringing the 2010-17 total number of new jobs to 17.8 million. The unemployment rate declined from 4.8 percent in January of 2017 to 4.1 percent by January of 2018. For perspective, the unemployment rate clocked at 9.8 percent in January 2010, not far from the Great Recession-high of 10.0 percent. Just as importantly, employment gains over this period have been broad-based, across most sectors.
The pace of economic gains was also reflected in the Federal Reserve’s monetary policy actions. The Federal Open Market Committee voted for three rate hikes during 2017, citing the low unemployment rate and signs of upward pressures on inflation. The Consumer Price Index (CPI) moved in a narrow range most of the year, around 2.0 percent, according to the Bureau of Labor Statistics. However, the cost of housing — both rent and owners’ equivalent rent, which comprise about a third of the CPI—advanced at a faster clip during 2017, averaging close to 3.5 percent. In addition, the Fed also moved toward further monetary tightening, when it announced in October of 2017 that it would commence divesting some of its $4.5 trillion in assets starting in 2018, by allowing maturing bonds to roll off its balance sheet without reinvesting the payments.
Commercial real estate matures
For commercial real estate fundamentals, the economic gains translated into solid demand for space. While the performance of each property sector offered more nuances in 2017, on balance, commercial markets recorded rising rents, placing cash flows at the center of shifting investor expectations.
This shift in investor expectations was a defining characteristic of the commercial real estate landscape in 2017. While the bifurcation in investment trends continued along valuation lines, with pricing reaching new highs and interest rates moving higher, investors refocused their strategies away from returns based on appreciation gains and cap rate compression, and toward cash-flow-centered returns.
The refocus was evident in transaction volumes and pricing. Investment volume in the large cap space closed 2017 with $463.9 billion in transactions, a seven percent decline from 2016, according to Real Capital Analytics (RCA). This marked the second year of sales declines. Sales volume declined in each of the four quarters, with the last one posting a 13 percent drop.
However, highlighting the more nuanced environment, prices in large cap commercial real estate markets advanced 7.1 percent year-over-year in 2017, according to RCA. All property types, except hotels, posted higher prices during the year, with the apartment and industrial properties recording higher comparative gains. Analysis from RCA pointed to a growing gap between sellers’ high price expectations and buyers’ willingness to pay those high prices. Cap rates spent most of the year moving sideways, in a narrow range of 6.7-6.9 percent. The fourth quarter of 2017 average across all property types was 6.9 percent, on par with the last quarter of 2016, according to RCA.
The common thread in commercial real estate markets over the past year was the continued increase in the profile of small cap metros and properties. While the six major markets tracked by RCA experienced a 14 percent decline in investment sales over the year, secondary markets’ sales volume slid by a moderate two percent in 2017, and tertiary markets’ investments were flat over the year.
The thread was also echoed by trends in REALTORS®’ commercial real estate markets, most of which focus on small cap transactions. REALTORS® reported advances in investment sales, as the momentum picked up in the final quarter of 2017. Following on the second quarter’s 4.4 percent increase and the third quarter’s 3.6 percent gain in sales volume, REALTORS® reported that sales volume advanced a solid 9.1 percent in the fourth quarter.
Mirroring large cap investors’ interest in rising fundamentals and higher yields, small cap markets remained an attractive environment. The shortage of available inventory—a defining market feature during this cycle—remained the number one concern for REALTORS® engaged in commercial investments. The dearth of inventory pushed prices for SCRE properties up, to the tune of a 6.9 percent yearly advance in the fourth quarter of last year. Echoing the large cap market trend, the pricing gap between buyers and sellers proved the second highest ranked concern for commercial practitioners. Anecdotally, REALTORS® indicated that while sellers expected high prices, many buyers were more targeted in their acquisition strategies, and more likely to focus on expected cash flow gains to drive valuations, versus cap rate compression.
Outlook remains cautiously optimistic amid rising interest rates
The longer-dated bond market remained tentative in 2017, even with the Fed’s rate increases. The Treasury 10-year note ranged from 2.17 percent in the first quarter to 2.29 percent in the third quarter, and settled at 2.25 percent by the end of December. However, the rate picked up speed during the first part of 2018, riding a precipitous curve and reaching a high of 2.94 percent on February 21 of this year. With the Federal Reserve signaling continued commitment to upward rate adjustments, most market participants expect three-to-four increases this year.
As investors scan the horizon for signs of change and risk, questions abound about the current cycle’s duration, timing, and outlook, in light of the expected upward march in interest rates. Are commercial real estate assets overvalued? Is there a price bubble? As we approach the 10-year mark of this cycle, are we headed for a downturn?
Over the next two years—barring external shocks—the U.S. economy is projected to continue expanding at a positive-if-moderate pace: 2.9 percent in 2018 and 2.6 percent in 2019. With the attendant gains in employment, the advance will maintain demand for commercial properties on a positive trend line. In turn, landlords can expect positive cash flows, especially for value-add properties. Looking at net operating income growth in 2017, it has been a major contributor to price gains, particularly for retail and industrial properties, and it is expected to play an important role over the next couple of years.
With cap rates flat over the past year and a half, compression likely reached its lower bound, and investors can expect rising rates to add upward pressure on yields. However, it’s worth noting that cap rates remain low by historical trends, in line with returns on most financial assets. Moreover, the spreads between caps and the 10-year Treasury note yield—a measure of investor compensation for commercial real estate risk—remain quite wide, especially when viewed through the lens of a longer-timed horizon. Investors in commercial real estate assets retain about a 400 basis-point cushion against rising interest rates.
Adding a bright line to the outlook, unlike prior cycles, debt financing has played a smaller role in the current expansion. Partly due to the regulatory environment and partly due to investor preference, equity capital has become a larger source of commercial real estate funding, exceeding debt placements in 2017. While commercial real estate debt instruments accounted for $3.76 trillion in 2016, they comprised $3.92 trillion in 2017. In comparison, commercial real estate equity investments totaled $3.97 trillion in 2017, a noticeable advance from 2016’s $2.85 trillion, based on an analysis by Situs RERC.
It is important to keep in mind this is a constantly shifting environment and risks are also evolving. With improving global economies, investors are finding attractive alternatives outside U.S. commercial real estate markets. With rising prices and shrinking inventory, investors are likely to shift some of their allocations away from U.S. metros and toward faster growing economies in Asia and Europe. Also, while the tax reform and a softer regulatory regime are expected to boost corporate investments in the U.S. economy, an unresolved North American Free Trade Agreement renegotiation, coupled with the administration’s proposed tariffs, could potentially provide negative shocks to prices and consumer spending.