What the mixed economic signals mean for commercial real estate
Despite a couple of developments to the contrary, certain economic indicators suggest the U.S. may be at the later stage of an economic cycle.
How is that possible when there’s been a double-digit return in the U.S. stock market in first quarter 2019 and with the Federal Reserve taking a 180-degree turn from its stance in 2018 that helped to bolster market sentiments?
According to research by Morgan Stanley in a segment labeled, “In Search of a Late-Cycle Safety Net,” earnings may start a downward drift of as much as 3% for the first quarter of 2019 year over year as a result of compressed margins, which in turn could cause pressures that could lead to an economic downturn.
Further, in research published by Goldman Sachs, Chief Credit Strategist Lotfi Karoui suggests the corporate credit markets, specifically BBB issuance, making up 50% of the market share of corporate investment grade debt, could be at risk for a downgrade if a substantial shock to earnings were to occur. That said, he seems to assign a low probability of that happening over a short time horizon or all at once given the current economic backdrop in the U.S. He also mentions that commercial real estate specifically has an overheated valuation across asset classes in the current economic cycle.
It’s important to note that many of the concerns expressed by credit investors are related to events that are yet to take place or are happening at a pace that is not a cause for immediate concern. The message seems to be that 2019 should still be a relatively stable year for the U.S. economy, but it is important to heed some of the factors that could eventually impact the overall economy and the commercial real estate segment.
Recent trends in the commercial real estate space seem to indicate that both investors and developers are signaling an understanding of the late cycle nature of the U.S. economy.
Apartment Projects and Condos
Among those trends have been the emergence of apartment projects coming online in many primary and secondary markets, despite there being a nationwide shortage of housing in many cities. According to an article published by Dean Jones of Realogics Sotheby’s International Realty, many developers with recent memories of the 2008-2009 real estate recession are taking the path of least resistance. Many of these projects were originally programmed as multifamily condo projects and later converted to apartment projects as a result.
Among the factors contributing to this shift are rising lending costs for condo developments, higher equity contribution requirements and higher insurance costs as compared to apartment projects, all factors pricing in higher risk premiums given the potential for defaults. In addition, the ability for income as an offset to market price volatility allows many developers to wait until the right moment to convert to condo projects and earn income and service debt more easily.
According to the Urban Land Institute’s 2018 “Emerging Trends in the Real Estate Market,” apartment development projects are the best investment market in the commercial real estate space. This trend is further catalyzed by the “work and play” mentality driven by millennial demand to rent in urban markets. This reurbanization movement has prompted a focus on amenities and socially responsible living versus the American Dream of home ownership. This may be further prompted by a generational reality of the negative effects of the last economic recession prompted by a housing bubble adversely altering the psyche of the newest generation of entrants into the real estate market.
An additional byproduct of this trend is the growth and reliance on e-commerce for everyday life, which has also had its own signature on retail and industrial asset classes. While brick and mortar is not obsolete, demand has helped morph the retail and industrial asset classes to be more sensitive to an ever-changing landscape. According to JP Morgan, “last mile” industrial repurposing of industrial sites in distribution-centric locations is occurring across the map. Retail is being converted across the nation to light industrial warehousing sites to accommodate e-commerce and digital purchasing platforms that act as delivery hubs for major centers. The idea is to maintain close proximities to major urban centers and act as a decentralized distribution channel for B-to-C consumption.
Though the cautionary tale is for developers and investors not to repeat the mistakes of the past, many investors are still on the hunt for real estate opportunities.
Some markets represent a good opportunity for investors with a longer time horizon. According to a report by GoBankingRates, several cities are likely to see delinquency and foreclosure rates go up in the next year. In the report, they ranked the top 40 cities likely to see declines, including Miami, Florida; and Chicago, Illinois. Not surprisingly, many investors and developers in both cities have made more recent shifts to core income assets like apartments, student housing, triple-net leased commercial and light industrial warehousing to diversify their portfolios and avoid the volatility that may be lurking around the corner.
Developers in Miami were among some of the worst hit in the nation during the 2008-2009 crisis, and memories are still fresh for most of the folks on the Suncoast. Nevertheless, for the right type of investor, these cities can represent an opportunity to absorb inventory in the near future at distressed levels and repeat the cycle of 2009. An abundance of vacant inventory was snatched up by opportunistic investors, mainly Europeans and Latin American investors looking to diversify their portfolios to hedge against currency and in some cases political risk in their respective countries.
In conclusion, 2019 seems to be poised for a strong year for commercial real estate across most asset classes, but there are clouds on the horizon. Lenders, investors and developers alike are heeding the warning signs and making defensive shifts to reposition their portfolios to weather any potential storm and avoid repeating some of the mistakes of the last economic downturn.