United States

A warning light for commercial real estate?

INSIGHT ARTICLE

Entering the late portion of the current business cycle, businesses are still feeling the effects of the recession. Overall, growth is sluggish and, in the long term, is expected to eventually level off to about 1 percent annualized growth. 

Real estate is certainly not immune to variabilities in the economy. While single-family home sales in 2016 rose 31 percent over 2015, setting the highest rate since October 20071, commercial real estate (CRE) has been facing a number of challenges: economic and political volatility overseas, the threat of another recession and the uncertainty that can after a presidential election. 

Following are highlights of trends in the CRE market that are worth watching in the coming months.

Growth in CRE 

The period of rapid growth in CRE has ended, and expectations are that growth will be limited going forward: Markets such as New York City, Austin and Los Angeles that have been saturated with the new construction will likely see apartment vacancy rates rise by more than 1 percent and will experience slower rent and net operating income growth. 

Construction of other types of commercial properties has been, and is likely to remain, limited for the time being. Consequently, the national vacancy rates for office, industrial and retail space declined steadily in the past two years and, unlike apartments, are expected to decline further in the next two years.

Leveraging real estate

Leverage in commercial real estate is increasing, but lax underwriting may be exposing lenders to greater risk. The Office of the Comptroller of the Currency noted in its Semiannual Risk Perspective an easing of “underwriting standards and practices in commercial lending as lenders strive for volume and yield”2 that is driving an increase in credit risk. Examples of these standards include less-restrictive loan covenants, extended maturities, longer interest-only payment periods and limited guarantor requirements.

“No one in the institutional real estate investment world wants to repeat the mistakes of the 2008 financial crisis, especially with respect to the underwriting and the due diligence process. In such a competitive environment, many buyers, lenders, owners and operators neglect to perform proper due diligence when verifying a property’s revenues and expenses,” says RSM’s Michael A. Schwartz, who heads the firm’s real estate advisory services practice. 

Millennials and multifamily 

The impact that millennials—those born between 1982 and 2000—have had on commercial real estate since the end of the recession has been very positive. More millennials are showing up in the workplace and bringing expectations of advanced technology being available, even in older office properties. Whereas premium office spaces were until recently located in the suburbs—presumably close to where employees lived—millennials are flocking to the urban locations and forcing employers to locate in the city. 

Increasingly, housing is also being affected by increasing demands for multifamily units, condominiums and cooperatives. With the increased pace of hiring, millennials are driving a significant increase in household formations. With the drop in the median sales price for new homes3—and a more stable job market—young adults are in a better position to afford starter homes. 

The impact of consumer sales on retail real estate

A profound structural change has taken place in retail. The move to online spending has been significant—U.S. online retail sales are forecasted to grow to $480 billion by 20194—and commercial real estate has felt its impact. Even Macy’s—among the industry’s top online retailers5—cannot keep up: The company announced it would be closing 100 locations (about 15 percent of its stores) nationwide by early 20176. Other well-known retailers, which often serve as anchors in shopping malls, are offsetting slumping sales and diminishing foot traffic by closing stores as well. 

With too much volume taken out of the market, a broad reimagining of these retail spaces will need to take place. Unless they can make a transition to serving upper-income demographics—for example, offering specialty retailers, unique restaurants and other amenities, located nearby multifamily dwellings—owners of these spaces will find themselves with valuable holdings but little else to show for it.

Notably, the growing share of e-commerce is having a positive effect on the need for distribution centers that enable retail companies to deliver products to consumers quickly. 

Rising costs and competition in hospitality 

New overtime rules for nonexempt employees, a rising minimum wage and a tight labor market, are having an impact on the hospitality industry. The labor-intensive  

nature of the industry—where few services can be provided by technology—will mean that some traditional services such as room service and fresh linens will be cut back, outsourced or eliminated in order to offset costs. 

Supply may be overwhelming demand. Increased competition in the form of Homeaway, Airbnb and other digital-sharing hospitality ventures—as well as new (or newly refurbished) hotels—will force prices down. 

Hospitality development in the United States is increasingly being financed by overseas investors—particularly from Asia—as well as other emerging sources, such as crowd-funding initiatives. But convincing lenders and other stakeholders to support development means being able to provide a distinctive brand experience in a highly competitive marketplace.

While older customers are accustomed to standard accommodations, younger consumers are attracted to innovative lodging. In an effort to attract this younger demographic, hotels are investing in high-tech amenities to help distinguish a franchise from its competitors as well as to generate income as consumer interest shifts away from core attractions. 

Post-election uncertainty

General uncertainty on policy issues is causing companies to hold back on spending.  Should a recession arrive in 2017 due to diminishing returns from monetary policy, there is a risk that political polarization will inhibit the need for fiscal stimulus. But there appears to be bipartisan agreement that the state of national infrastructure is holding back growth. A five-year highway spending bill, the Fixing America’s Surface Transportation Act, signed into law in late 2015 should help provide jobs as well as help rebuild roads, bridges and transit systems.7

Policy uncertainty persists nonetheless, and many economists argue that this is having an adverse effect on the economy overall.8  How this will play out for commercial real estate remains to be seen.

 

1 Irwin, N. “The Housing Market Is Finally Starting to Look Healthy,” The New York Times (Aug. 23, 2016)

2 Semiannual Risk Perspective, Office of the Comptroller of the Currency (Spring 2016)

3 U.S. Census Bureau (Aug. 2016)

4 “Online retail sales to top $480 billion by 2019,” Forrester Research, Inc. (Apr. 22, 2015)

5 Top 100 Retailers 2015, National Retailers

6 Egan, M. “Macy's is closing another 100 stores,” CNN Money (Aug. 11, 2016)

7 Laing, K. “Obama signs $305B highway bill,” The Hill (Dec. 4, 2015)

8 Davis, S. “Policy uncertainty matters,” Chicago Booth Review (Mar. 10, 2014)

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