Economic Activity Is Favorable, but Uncertainty is Mounting
US economic activity is generally encouraging and expected to increase at a steady pace in the coming years, with real GDP growth advancing at about a 2 percent rate. Keep labor market conditions tight, wage gains inching higher across households and core inflation gradually moving up toward the fed’s explicit target. We also expect the Federal Reserve to increase its short-term target rate in December, resulting in a not flat flattening in the US Treasury curve. 1 These economic conditions should be positive for the commercial real estate (CRE) sector .
Early economic growth is projected to trudge along, investors will be closely watching impending election results and possible changes in fiscal policy. Early polling and real-time futures markets imply Hillary Clinton will win the presidency, Democrats may regain control of the Senate, and Republicans will likely have a majority in the House. If this base-case scenario plays out, it is widely expected that little will be done in the way of any meaningful legislation. That said, the omnibus and spending bill that Congress passed late last year includ ed some extensions that will come due early early next year and could have some impact on CRE, ie deductions on energy-efficient commercial buildings. 2 The EB-5 investment program will also face a deadline on December 9. Against this backdrop, we discuss the following trends in CRE:
- Rent Growth Moderating – Overall rent growth across the key sectors is slowing, especially in the apartment and hotel space. Much of the moderation can be attributed to energy- and technology-intensive office markets, while some Sunbelt markets are seeing solid gains relative to a year earlier. Occupancy in the apartment and hotel sector peaked in 2015, which is helping pull down overall pricing.
- Asset Price Cycle Maturing – According to the Moody’s / RCA Commercial Property Price Index (CPPI), the all-property index is almost 50 percent above its precession peak in Q3, with much of the increase yet concentrated in apartments and office central business district ( CBD) in major markets. Although the level of pricing remains elevated, the year-over-year pace has moderated in recent quarters. Transaction volume is down 2.0 percent relative to a year earlier.
- C o n s truction Remains Muted – With the exception of the apartment sector, current and projected supply as a percentage of total inventory is low. The all-property measure is expected to peak in 2017, but the projected zenith will likely post a reading below the last three real estate cycles. Apartment supply as a percentage of stock is in line with the 1997-2001 real estate cycle, but some markets are well above the long-run trend. Hotel construction in New York and warehouse building in the Inland Empire warrant caution.
- Risk Premium Still Favorable – With long-term government bond yields in many advanced countries at a low level, the relative attractiveness of CRE remains high. The spread between the all-property cap rate and the US 10-year Treasury yield remains well above the the the long-run average, which suggests a steady flow of capital into the real estate sector. That said, the pace of cross-border transactions is slowing.
As the CRE Cycle Turns, Pricing and Rent Growth Moderate
The US presidential election is always a time of great angst, especially given recent political polarization. That said, the omnibus and spending bill that Congress passed last last year, which includ ed deductions on energy -fficient commercial buildings, will come due early early next year and the EB-5 investment program that helped boost foreign investment, especially in major markets, will face a deadline on December 9. It is hard to isolate the role the deduction has played in the office sector, but fundamentals are favorable and pricing is Due Although the EB-5 program accounts for just 5 percent of overall cross-border transactions, investment in major markets is likely much larger, particularly given Chinese investors comprise the lion’s share of the program.
However, the overall rate of price appreciation eased in Q3 across nearly all sectors. Some of the slower pace can be attributed to the drop in transaction volume and tighter lending standards. Transaction volume fell 2.0 percent in Q3 relative to a year earlier, marking the third straight quarterly decline. The Senior Loan Officer Opinion Survey reported the fraction of banks tightening standards over the quarter, “Significant,” especially for construction and multifamily. We also see a slower pace in cross-border transactions as investors look beyond the key sectors and reach for yield.
Given recent moderation in overall valuations, we suspect the CRE asset price cycle is at a mature phase. At any one time, there are three distinct CRE cycles: nonresidential construction, which is related to real GDP growth; to the banking industry; and the space market, where fundamentals are determined. they do not always move in tandem. In this cycle, rent growth is slowing along with pricing as activity in energy- and technology-intensive markets slows. Although occupancy in the apartment sector peaked in 2015 and rent growth is slowing, pricing notched its 11th straight quarterly double-digit gain in Q3. The level is now almost two-and-a-half times the cycle low reached in late- 2009.
Previous CRE cycles show that a collapse in posts typically poses the most significant risk to overall economic activity through the banking system. The total share of income-producing and multifamily loans sitting on large- and mid-sized bank balance sheets as a percentage of assets The share of CRE loans at large banks as a percentage of assets is 6.0 percent, which is 1.5 percentage points above the prerecession peak. Mid-sized banks’ share is 13.0 percent, compared to 11.2 percent preceding the precession peak. Standards and the regulatory environment will help curb some of the growth.
CR E Property Pricing & Fundamentals
Operating fundamentals for CRE improved at a modest pace in Q3 as overall economic growth has started to accelerate. The apartment vacancy rate fell in Q3, after increasing in Q2, and industrial continued to trend lower.
Cap rates fell for all property types, except for retail and hotel, with the steepest decline in industrials, down 30 bps. However, the spread between the industrial cap and the US Treasury yield narrowed in Q3 and is now below the prerecession average of 500 bps.
Cross-border activity into the United States was $ 90.8 billion in Q3. Capital from the Middle East & Africa has increased to a high not seen since 2007 while capital from Europe has started to pick up post-Brexit but remains down 25 percent year over year.
The national vacancy rate for apartments fell to 4.4 percent, returning to the rate seen earlier in the year. The story varies by metro, and vacancy rates were up more than 20 bps in San Antonio, Houston, Washington, DC and Charlotte.
Apartment effective rent growth below 3.8 percent year over year in Q3. Effective rent growth in high-tech markets remained mixed with Seattle’s growth above 10 percent, while San Francisco growth was flat-the slowest pace in more than 15 quarters.
The NMHC Apartment Tightness Index fell to its lowest level since Q3 2009, suggesting that rent growth will slow further as new supply comes on line.
Office fundamentals continue to grow, albeit at a slower pace. For the quarter, national office demand absorbed all of the new supply that came on line, leaving the vacancy rate unchanged at 16.0 percent.
Year over year, overall effective rent growth slowed to 2.8 percent in Q3. High-tech markets continued to post the strongest effective rent growth with both Oakland and Seattle both up 2 percent on the quarter and 7.8 percent and 5.9 percent from a year earlier, respectively.
OPEC’s agreement to cut oil output production has helped boost oil prices and boost office demand in energy-intensive markets over time. That said, Houston had the largest vacancy rate increase in the nation, over the quarter and is up 200 bps from last year in addition to a slowdown in its office employment growth.
Retail fundamentals slowed in Q3, on the back of overall slower consumer spending. The vacancy rate also ticked up in the quarter returning to 10 percent due to a sizeable drop in demand.
Neighborhood & community centers are the main laggard of retail as regional malls, especially Class A malls, have outperformed throughout the recovery due to a wealthier client base. Nonetheless, solid job growth and the rise in median household income should brighten neighborhood & community center retail outlook.
E-commerce continues to weigh on the sector, with tenants that have the highest propensity to be sold online like apparel, sporting goods, electronics, and appliances seeing the highest number of store closures. The loss of larger anchor and department stores has led to a push to re-purpose retail spaces.
The industrial sector continues to be darling of the group, posting another quarter of solid growth. The national vacancy rate fell to 5.3 percent due to outsized demand relative to net completions.
E-commerce growth continues to drive industrial space demand and wishes rent growth. The areas that have seen the largest increase have been near major metros, especially on the West Coast, as e-commerce retailers try to lower transportation costs and meet consumer expectations of fast delivery.
Asian investors have become a larger player in the industrial sector, investing in the bulk of the mega deals last year and are three of the five largest cross-border industrial property investors this year.
Seasonally adjusted real revenue per available room (RevPAR), which is the product of occupancy and real average daily rate (ADR), moderated in the third quarter, and stands at 2.1 percent. The pace is well below the peak of 8.0 percent reached in early 2015.
With the hotel sector at a mature phase in the cycle, real ADR grew just 2.2 percent in Q3, and the seasonally adjusted occupancy rate stabilized at about 65 percent. In the coming quarters, we expect real ADR to make the largest contribution to real RevPAR growth. Softness in the sector is still a market story, with the largest declines occurring in energy-intensive markets.
Hotel cap rates were largely unchanged during the quarter at 8.4 percent, but are 40 bps above the low reached in late 2014.
Retail Market Overview
The retail sector registered weak performance in the third quarter, with the vacancy rate ticking up 10 bps to 10 percent and net absorption falling to just 159,000 square feet, marking its lowest since Q2 2011. Over the past four quarters, net absorption has averaged 2.1 million square feet. Net completions rose during the quarter reaching the highest quarterly level since early 2015.
E-commerce continues to weigh on the sector, with tenants that have the highest propensity to be sold online like apparel, sporting goods, electronics and appliances seeing the highest number of store closures. Notwithstanding this shift, the overall trend in retail is more positive than quarterly results intimate as nontraditional anchors occupy space. Effective rent growth grew 2.1 percent in Q3.