Commercial Real Estate Outlook: Shifting Gears

The commercial real estate outlook seems brightest for those investors who are proceeding cautiously even before any signs of an economic downturn become apparent.
Image by Newbird/iStockphoto.com

The economic expansion turned 10 this summer, making it the longest continuous period of growth in U.S. history. While most observers agree the current cycle is likely in its latter stages, opinions on the commercial real estate outlook differ widely as to when a recession will finally hit and how severe the downturn will be. Investors, developers and lenders must weigh strategy for today’s conditions while remaining mindful that a slowdown is inevitable, however uncertain the timing.

“Where we are in the cycle is a topic that’s on all of our clients’ minds, but I don’t see the trigger that causes us to go into a recession,” said Aaron Jodka, managing director of client services at Colliers International. Debt loads are a concern, whether for consumer credit cards, student loans or the balance sheet of the Federal Reserve. But, he said, “it’s possible the Fed is able to work the soft landing, where they cut rates a little bit if the economy continues to cool, and we avoid a major downturn.”

READ THE GUIDE

Worried about interest rates, trade tensions and a possible late-cycle slowdown, investors started the year cautiously. Anthony Graziano, chairman of Integra Realty Resources, sums up the investor’s dilemma as “What to do with my money, and where do I put it for safety.”

Transactions dropped 11 percent year-over-year in the first quarter, according to Real Capital Analytics Inc. Sales declined in all sectors except for multifamily. Through May, volume slipped 9 percent to $177.4 billion.

Jodka Aaron
Jodka, Managing Director of Client Services, Colliers International. Photo courtesy of Colliers International

By midyear, investment was rebounding. Second-quarter volume ticked up 2 percent year-over-year to $127 billion, despite the dearth of entity-level deals that accounted for only 3.9 percent of sales, well short of the typical 8 percent share, RCA reported. “The past several months have seen new green shoots of optimism in response to rebounding equity markets, exceedingly stable jobs figures and a stronger-than-expected reading of first-quarter U.S. GDP,” reported Lauro Ferroni, director of capital markets research at JLL.

The Federal Reserve’s decision to hold the line on interest rates has helped ease investor concerns. Lenders report a push by borrowers to take advantage of the improved environment. “It has created a broad set of opportunities for us to look at and pursue with our clients,” said Ken Rogozinski, executive managing director at Greystone Bassuk.

Confidence boosters

While real enough, the improvement in confidence remains guarded. An annual survey by national law firm Akerman found that 70 percent of executives are more optimistic about the market than they were in 2018, but 37 percent report feeling only marginally more upbeat. Participants cited uncertainty surrounding interest rates, global economic conditions and federal policy as top worries.

Lauro Ferroni
Lauro Ferroni, Director of Capital Markets Research, JLL. Image courtesy of JLL

Other studies reveal similar ambivalence. At midyear, the RCLCO Current Real Estate Market Sentiment Index stood at 49.2, up from 37.2 at the beginning of 2019. Yet that represents a 19-point decline from mid-2018, and RCLCO estimates that the score will slip to 41.5 next year. The survey also indicates widely varying views of market potential. While 63 percent say that retail is in a downturn—or will be in 12 months—only 17 percent say the same of the industrial sector.

About 40 percent hold that view of the hospitality, office and multifamily sectors.
Another trend figuring into second-half investment strategies is the expanding role of Opportunity Zones. A turning point was the Internal Revenue Service’s publication in April of a second round of guidance, which provided long-awaited clarification of the program’s ground rules. Advisory firms report an uptick in conversations with investors about Opportunity Zones, but also offer a word of caution.

“Now is the window to be seriously considering investment in an Opportunity Zone, and if sponsors are really looking at those kinds of transactions, they need to be really mindful of pursuing them in an earnest fashion,” Rogozinski said. “You get more benefit by closing now … on those assets than in 12 months or 18 months.”

The Opportunity Zone designation appears to be having a salutary effect on investment. Starting with the first quarter of 2018, property and land sales volume in Opportunity Zones has been consistently increasing year-over-year, Real Capital Analytics reported in June. Meanwhile, zones that were eligible but were not selected for the program tell a different story. By the fourth quarter of 2018, investment sales in those also-ran zones were declining. 

Easy does it

Some investors’ commercial real estate outlook is such that they are already easing into the slowdown by reallocating capital to growth engines such as self storage, medical and senior housing, as well as to select pockets of office assets. “The multifamily and industrial sectors are posting rental growth rates of two or more times what we are seeing in the office sector,” said Ferroni. “Investors’ shifts here are already manifesting themselves.” During the past two years, the multifamily and industrial sectors have represented one-and-a-half times the share of acquisition volume that they did during the pre-Great Recession period.

Carter Andrus
Carter Andrus, Managing Director of Capital Deployment for the Central U.S., Prologis. Image courtesy of Prologis

Another strategy is to look beyond the acquisition of existing assets and toward development opportunities in the next market cycle. “The pivot that we’re starting to see in the last several months is major land purchases,” said Jodka, who is based in Boston. Investors in that metro are acquiring parcels with an eye on the future. “It used to just be open land—dirt that never could go anywhere. Now it is surging with demand,” he said.

Last year, 35 percent of all suburban absorption in Greater Boston was driven by life science companies. While Cambridge, Mass., is a national leader for pharmaceutical and life science research, the existing inventory is essentially fully occupied. That is creating opportunity for large-scale developments like DivcoWest’s Cambridge Crossing, a 43-acre site that will encompass 2.1 million square feet of science and technology space, 2,400 residential units and 100,000 square feet of retail at full build-out.

No matter where the cycle may be, Prologis practices discipline in expanding its 772 million-square-foot global logistics portfolio. “This is key to weathering any downturn,” argues Carter Andrus, managing director of capital deployment for the firm’s central U.S. region. “We only build and hold properties that will outperform throughout the cycle. From a tenancy perspective, we’ve applied lessons learned to our portfolio today; this includes better credit leases with longer terms than prior,” he added.

You’ll find more on this topic in the CPE-MHN Guide to Investing 2019.