Posted 3 months ago

2019 Commercial Real Estate Outlook: Trends, Opportunities, and Predic

At the beginning of each year, I take a step back to think about the state of the commercial real estate industry; the major trends, investment opportunities, technological innovation, macroeconomic conditions, and other factors impacting the space. It’s important to step away from the minutia of our day-to-day and evaluate the bigger picture. Before I write this annual article I spend a few weeks reading a variety of reports, market studies, white papers and interviews with industry leaders. I listen to number of podcasts and speak to some of my friends in the industry about what their expectations are for the upcoming year. After I let it percolate, I try to summarize all of the content into a digestible 15 minute read. Here it is.

Macroeconomic Conditions

We’ll start with the state of the US economy. It’s a tough place to start because nobody can predict the future, even the brightest economists seem to get it wrong most of the time. With that disclaimer out of the way, the general consensus among economists is that the economy in 2019 will stay healthy. Most economic indicators show favorable conditions (e.g. strong employment, GDP growth, and consumer confidence). Most economists suggest that the real estate cycle has reached or surpassed its peak. Coming off a peak does not mean that we will necessarily face a sharp correction. Most economists believe that the next correction, whenever it comes, will be much less drastic than that of 2008. Economists always say the next correction will come in 18-24 months. They’ve been saying that for the last few years and they will likely be saying it into 2020. So take this, or any other economic prediction, with a grain of salt.

Real Property Price Index(Real Capital Analytics)

Cap Rates

Cap rates have been at historically low levels for the last 5-7 years, in large part due to the historically low interest rates resulting from the severity of the financial crisis. When the risk free benchmark, the 10-year treasury is below two percent, then a 4 or 5 cap rate doesn’t look too crazy because of the spread; which is why properties continue to trade at ridiculously low cap rates. Despite several interest rate hikes by the Fed, cap rates remain historically low. However, uncertainty about what the future holds, coupled with extremely low cap rates, has been the primary reason investment volume has declined recently. Even though deal volume hit it’s peak in 2015, pricing remains very high as investors have little incentive to sell. Where else are they going to find better risk-adjusted returns? Cap rates tend to lag changes in interest rates but, the spread is becoming too thin and in late 2019 cap rates will likely increase.

Real Capital Analytics

Deal Volume

Deal volume increased again in 2018. The total volume of transactions marks the third-highest annual level of transactions on record. As you can see from the graph produced by Real Capital Analytics, deal volume across all major commercial sectors rose in 2018. Industrial and multifamily transaction volume reached new records. 2019 should be another great year for real estate transaction volume. I can’t imagine we will see more volume than 2018 but, there is no reason why deal volume won’t remain high.

Technology

It’s safe to say that technology will continue to permeate the commercial real estate space. Technology is impacting almost every facet of industry, from development, to construction, to brokerage, to asset management and leasing, to property management. We’ve seen platforms like VTS greatly improve the asset management and leasing of space. We’ve seen technology play a huge role in improving the efficiency of transaction due diligence, institutional investment execution, and even private investment in real estate through crowdfunding platforms.

The questions we should ask in 2019 are: Will technology improve efficiently and enhance productivity? Are intermediaries, like brokers, more vulnerable to disintermediation than previously thought? Will the availability of data commoditize the space like we’ve seen in residential real estate?

I don’t think that big data will have the substantial impact on CRE that it has on residential because the data are far less homogenous, commercial properties are much more unique, and investment choices are much more complex. Intuition and gut will continue to be one of the major forces at play as companies make investment decisions. However, the use of data will play a larger and larger role moving forward. Part of what I do as an asset manager is to analyze data. Until recently, asset managers rarely, if ever, compiled and analyzed data. Not only that, many commercial real estate firms are hiring data analysts to assist in this endeavor to compile and make sense of data. The ability to gather, analyze, and used data and analytics will continue to permeate the space as it has in virtually all other industries.

The technologies I intend to keep an eye on in 2019 and beyond are: blockchain, construction tech, and the aggregation and use of big data. Real estate tech investment continues to climb. The graph below, created by CB Insights demonstrates how global investment in real estate technology has increased by 4x since 2014.

PropTech Investment –CB Insights

Interest Rates

As I write this in February 2019, interest rates have actually been on the decline. The outlook is that the Fed will, however, make two additional rate hikes this year. This will inevitably impact investors, cap rates, the volume of transactions etc. The Fed may choose to change their outlook and make more or few hikes this year. As always we need to be prepared for interest rate hikes.

Opportunity Zones

The extent to which the tax incentives associated with investment in qualified opportunity zones will meaningfully impact the amount and location of real estate investment is yet to be seen. 2019 will be a landmark year in which the policy will be better defined and operators/sponsors will begin raising and deploying funds into these areas. This new tax incentive program, part of the 2017 tax reform package, was created to encourage investment in blighted areas. It’s difficult to predict how much money will flow into QOZ’s and what impact it will have on the returns of commercial real estate investment. Nevertheless, this is one hot new piece of legislation, like that of the landmark 1031 exchange, that could significantly increase the quantity of investment in real property.

As you can see from the graph below, the number of sites purchased in Qualified Opportunity Zones increased markedly in 2018 and will likely continue into 2019. Fortunately for real estate investors, many of these so-called blighted areas, are experiencing gentrification and are on the border of quality areas. Given the number of QOZ’s, investors will likely find many opportunities that they would have otherwise invested in without the generous tax breaks of OZ’s. My suggestion is that investors should not allow the opportunity zone designation have any impact on whether they would pursue a deal. Make sure that the projected returns are sufficient without incorporating the tax breaks. Stated differently, don’t let the tail wag the dog. Only invest in QOZ projects that you would have invested in without the QOZ tax perks.

Product Type Outlook

The outlook for the commercial real estate industry as a whole is favorable/strong/good. Subtle nuances differentiate the best performing sectors from those at the bottom. One of the primary drivers impacting this distinction is the role of technology. In other words, technology is impacting every sector in either a positive or negative way. Most obvious is the stark contrast between the retail outlook and the industrial outlook.

E-commerce is driving cap rates to all-time lows in the industrial sector, whereas this same technology has been one of the main drivers of many retail bankruptcies. Technology plays a key role in the way businesses think. The way businesses think impacts their office space needs, which impacts where and how their employees live. As technology forces companies to be more flexible and iterate at a much faster pace, their physical office space must also be more flexible. Naturally, their employees must be more flexible and mobile. As such, office leases are shortening and the demand for multifamily product remains robust.

Retail

In my opinion, the most interesting sector in CRE right now is retail. It’s interesting because it undergoing a massive change. The Darwinian nature of retailing has been on full display as many household names have shut their doors for good. Despite the headlines, retail is not dead, it is simply undergoing a major transformation.

The US has significantly more retail real estate per capita than any other developed country. Much of this excess product will soon become obsolete as demand decreases. Fortunately, the dirt on which these building are located is generally very good. This will open up the door to more multifamily development which will help our big cities cope with housing shortages. Low-quality retail product needs to go away, but high-quality retail product is thriving. I don’t see this changing any time soon. We all enjoy getting out of our homes and enjoying a good meal and entertainment. Experiential retail, service oriented, low price point, and non-discretionary products will continue to be in high demand moving forward.

Department stores, luxury apparel, and commodity products that can easily be reviewed and purchased online are still at risk of being eliminated. Big-box and department stores will continue to reduce their store footprint as they evolve their omnichannel efforts. We will continue to see retail transform from a place where consumers buy durable goods into a place where consumers enjoy services and entertainment. Restaurants, health and fitness providers, urgent care and other medical, dental, and entertainment venues will continue to backfill junior boxes, department stores and in-line space.

With a significant amount of retail property becoming available, entrepreneurs may find opportunities converting larger structures into distribution warehouses, entertainment uses, medical, self-storage, or mixed-use developments. There is a significant amount of well-located retail property that is vacant and will not likely ever come back as retail. A great opportunity exists for those who can convert these structures into alternative uses because they can be purchased well below replacement cost.

New business patterns mean new landlord strategies and metrics for real estate and tenant health. As retailers focus more and more on their omnichannel shopping experience, the traditional rent-to-sales metric loses its value. In addition to this metric, landlords should look to the tenant’s online reviews, their customer service, and social following. Landlords need to be aware that many retailers’ in-store sales will decline as their customers buy online with greater frequency. Landlords who rely on percentage/overage rents, will need to consider that many of tenant’s sales will be coming for online and therefore, won’t be factored into their store sales.

Due to the need for retailers to reinvent themselves more frequently than in the past, they are seeking shorter lease terms. This preference for tenant flexibility will continue to put downward pressure on lease term. Nothing exemplifies this trend more than the many pop-up stores entering malls, department stores, and shopping centers.

Industrial

The industrial sector should continue to be one of the best, if not the best, performing product types in 2019. There has been no slowdown in e-commerce. E-commerce represents under 20% of all retail sales which indicates that growth will continue into the foreseeable future. Amazon has set the standard for shipping times, by providing customers with next-day or two-day shipping, and in some cases same-day delivery. Other retailers know they need to do the same in order to compete. This trend results in a greater demand for infill opportunities that will enable them to quickly complete the “last mile” of delivery.

On the supply side, increasing construction costs, regulatory burdens, and a lack of favorable land, has kept growth in new inventory contained. This is one of the reasons why pricing has reached an all-time high. One-third of new development of industrial product has been concentrated in just a handful of markets: California’s Inland Empire, Dallas, Atlanta, and Pennsylvania. Industrial developers look to vacant big boxes, movie theaters, and malls as potential locations for last-mile distribution centers.

The industrial sector faced a slight correction in the first part of 2018. Occupancy and rent growth decelerated and vacancy rates picked up a bit due to the amount of supply that hit the market in 2018. We’ve seen more supply come online in the last three years that ever before. Levels of supply have increased in each of the last three years. Supply should continue to be strong in 2019. Overall, the sector is strong and doesn’t show any signs of concern. The coasts are showing strong rent growth, particularly in San Francisco, Seattle, Los Angeles, New Jersey and New York. Those in this sector should stay on top of what’s going on with trade war as that could have an impact on demand.

The rise of this sector has not gone unnoticed. More and more investors are flocking to enter this sector and find a safe harbor for their capital. This rise in demand has pushed down cap rates and driven up values. With cap rates being driven lower and lower in primary markets, investors a venturing out on the risk spectrum by investing in secondary and tertiary markets.

Multifamily

Pricing for multifamily properties in primary markets remains steep after reaching the peak of the cycle a few years ago. Investors are focusing on secondary and tertiary markets to find greater yield. Value-add buyers need to be very careful with their underwriting assumptions as the market may soften and rents are likely not to grow as they have previously. Value-add opportunities this late in the cycle carry a significant amount of risk and managers and investors should only pursue these opportunities if they have a proven track record of success in late-cycle investments.

Fortunately, the supply-demand imbalance and favorable demographics will continue to prop up occupancy rates into the foreseeable future. The main challenge in this sector is the ability to capitalize on the demand for class B product. The supply of class B product does not meet the level of demand. Developing class B product, however, does not pencil because the cost to build is nearly equal to the cost to build class A. Therefore, the new supply hitting the market caters to the luxury apartment sector despite the majority of demand being driven by class B residents. This is why many multifamily operators are rehabbing class C product into class B product.

Office

The office property type can be characterized as healthy. Deal volume was up in 2018. Most of the transaction activity early in this cycle was in the central business district. Recently, there has been more activity in suburban office. Investor interest shifted to the suburbs for two reasons: (1) better yield; and (2) the demographic shift (the labor force is moving to the suburbs in greater numbers). On the yield side, average cap rates are 100-150 basis points higher in the suburbs than the CBD. Regarding the demographic wave, millennials want to live, work, and play in the suburbs. They are growing up, getting married, and having kids. They want to live in a suburban community that has good schools and is safe. Since the labor force is moving to the suburbs, the demand for office space will likely follow. These factors contributed to the year-over-year price increase for suburban office.

Office vacancy rates remained flat in 2018; they have remained at around 13% for the last 2-3 years. Tech companies continue to be the largest force on the demand side; therefore, investors should look to markets with projected growth in the tech sector.

One of the more prominent trends shaping the office sector is the rise in coworking space. Just a few years ago, many seasoned executives considered WeWork, just a hip version of Regus that would likely fade in just a few years. Quite the opposite has occurred, as Blackstone, Brookfield, and the Carlyle group each entering the space. Flex space, which I’ll define as built out office space that companies can lease for less than three years, is also on the rise. These two office space trends will continue because they meet the growing needs of businesses that demand more flexible lease structures. It’s about time owners of office properties develop an office space solution that mirrors the needs of their customers.

Less me space, more we space

Office design has evolved in recent years. Companies are designing their offices to improve collaboration and teamwork and foster casual collisions. The debate about whether the open office improves productivity and collaboration continues to rage. Very few studies have actually looked at whether or not an open office achieves the goals it sets out to achieve. The one study I found, however, indicated that open offices actually decreased the amount of collaboration and spontaneous conversations. Many companies are building open offices with no private offices to please the millennials. As a millennial, not only do I prefer working in my own private office, but I get more done because I can focus without being distracted. I predict that this age of completely open offices will begin to change in 5-10 years.

Capital Markets

Debt

Lenders have been much more conservative and cautious as we approach the end of this cycle compared to the run-up to the last cycle in the earl 2000’s. The improvement in debt underwriting standards, coupled with more disciplined business plans from real estate developers and investors, is something positive that real estate community can point to.

Going into 2019, we will see more and more debt chasing commercial real estate opportunities. Most experts project that banks will be more willing to lend this year than in 2018. In general, banks are easing credit standards and have a slightly higher appetite for risk. This will result in more money going around than there are solid deals. Anytime there is more money than quality deals, loan-to-value ratios go up. Rising LTV’s were a trend in 2018 that will likely continue into 2019. Fortunately for developers and investors, there is plenty of money chasing good deals. The challenge for developers and investors in 2019, will be finding projects that pencil out.

Inflation is likely to rise in 2019 and the years following. The increase in inflation will put upward pressure on interest rates and cap rates in 2019 and beyond.

Foreign Investment & Private Investment

Foreign investors perceive US commercial real estate as a safe haven for their money. It will be interesting to see how international relations, trade wars, globalization and other forces impact the flow of foreign money into US real estate. This will predominately impact gateway cities and trophy assets; however, if foreign investment grows, we can see that capital flow into secondary markets which will drive up prices and lower yields. Conversely, if foreign capital dries up, cap rates may rise and the volume of transactions may fall.

Private investment in US commercial real estate should continue to rise. This rise in private investment is due to less stringent securities laws, the reach technology plays in bringing together sponsors and investors, and the amount of money sitting in 401k’s and IRA’s that will look to be deployed into alternative assets.

Crowdfunding

Real estate crowdsourcing remains in its infancy. Many of you probably didn’t even know that real estate crowdfunding exists. It does, but it represents a very small sliver of the pie. Crowdsourcing platforms have only been around for about five years. Although they have grown in popularity and in assets under management, it’s still an unproven concept. I don’t think we will know how successful, or unsuccessful, real estate crowdfunding will be until the next downturn.

Real estate crowdfunding was enabled by a loosening of securities regulations and the acceptance of web-based investment platforms. Most of these real estate crowdfunding platforms were established by technologists rather than experienced real estate practitioners. This is why I am cautiously optimistic about how these platforms will perform through the next cycle. Even though I am concerned about how they will perform during and after the next downturn, I feel that everything else points to the potential for crowdfunding platforms to take off: broad acceptance of crowdsourcing in other industries, increase in private capital looking to enter the real estate space, the ability to match sponsors and investors much more efficiently, the ability to improve the liquidity of real estate investments, and more favorable treatment of real estate by US tax law.

Other Interesting CRE Topics

Construction Costs Skyrocketed

High construction costs have limited new supply and caused double-digit increases in rents. The three L’s have all peaked: land, labor, and lumber (materials). Land is expensive, especially in strong locations where millennials want to live, work, and play. Compounding the high property prices, is the shortage in construction labor. This shortage has led to a marked increase in the cost of labor. Materials costs, including lumber, have risen, further jolting up replacement costs.

Affordable Housing

In major cities across the country, too much of the population is either unable to afford housing or spending over half of the income toward housing. San Francisco is the poster child for unaffordable housing and a staggering homeless population, but throughout the country, families are struggling to afford housing near their place of work. Something needs to be done. City governments need to reduce the number of restrictions placed on developers, and improve the predictability speed of the entitlements process. Governments also need to realize that rent control is not a solution; rent control only exacerbates the affordable housing problem.

Top Markets for Investment in 2019

According to the Emerging Trends in Real Estate Report 2019, produced by PwC and ULI, the top market in the US in 2019 is … Dallas/Fort Worth! Second on the list is New York-Brooklyn, followed by: Raleigh/Durham, Orlando, and Nashville–rounding out the top five.

Final Thoughts

I expect 2019 to be another great year for commercial real estate. I am optimistic about the future despite being 10 years into the current expansion. I do recommend investors proceed with caution and make sure that they are using conservative underwriting assumptions. The severity of the last recession has resulted in significant price appreciation and increased demand for space across all asset classes. This has masked bad investment decisions and poor execution. Given where we are at in this cycle, we need to be conservative and manage our assets at the highest level because we can’t continue to count on improving market conditions to bail us out.



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