People, Get Ready for Extended Slowdown in CRE Demand

An inverted yield curve and forecasts of a dropoff in job growth are among the signals that the industry’s long, great ride may soon be ending, says economist Hugh Kelly.

In the military, they call it “short-timers attitude.” In high school, “senioritis.” In politics, “lame duck season.”

For real estate, we have “late cycle syndrome.”


Hugh F. Kelly, PhD, CRE
Hugh F. Kelly, PhD, CRE

A who’s who of the commercial property cognoscenti gather each December in New York for ULI’s McCoy Symposium. Late cycle risks were a prominent topic of discussion. Risk pricing, for instance, was seen as ripe for adjustment with cap rates rated as “too low” given prospects for income growth and capital appreciation. One participant suggested that a downward price correction of about 10 percent could actually be healthy for the industry. Lenders have generally been disciplined, but those financing projects at the riskier end of the spectrum may face trouble as the cycle turns. These include regional banks financing construction projects and mezzanine lenders who have not delved deeply enough into property inspections. Then there are niche investment areas, including self-storage, senior housing and student housing, where there has been a surge of development that may be outstripping underlying demand.

There is surely value in acknowledging that the business cycle is running out of steam, and the real estate cycle with it. For some time now, these columns have been advising that the smart money should be playing defense. A year ago, this space indicated five imbalances to monitor: labor conditions, the housing market, excessive equity market valuations, the flattening yield curve and potential sudden disruptions.

Economic Indicators

Despite the stimulus of the 2017 tax cuts and an outsized Federal spending spree, labor market constraints kept employment growth between 1.4 and 1.8 percent (year-over-year) from January to December 2018. Job gains averaged 220,000 per month, about the same as the prior four-year period and well below the 250,000 achieved in 2014. And I wrote in this column in September, the Congressional Budget Office is forecasting a sharp slowdown in job growth beginning in late 2019.

New single-family home construction contracted 1.9 percent year-over-year as of November 2018 (the most recent data available, due to the government shutdown that has delayed release of year-end 2018 statistics). The National Association of Home Builders’ Housing Market Index stood at 58 in January 2019, down substantially from 72 a year earlier. Average fixed-rate home mortgages were 4.54 percent in 2018, up 55 basis points over 2017 and the highest since 2010. Unsurprisingly, housing appreciation is slowing and nationwide it takes an average of 87 days to sell a home. observes that sellers are more frequently cutting prices in an effort to stimulate purchaser bids.

In November and December, the equity markets exhibited extraordinary volatility, and all the major stock indexes lost value during 2018. The usual daily rationalizations of the markets’ movements should be largely discounted as displaying what Nassim Taleb calls ‘the narrative fallacy’―our tendency to ascribe simplistic, short-term cause-and effect stories to complex economic stories. Fundamentally, however, the markets’ fragility reflected two major conditions. The first is that the two-year, 44 percent rally in stock prices―which came on the heels of a seven-year bull market that had already seen values rise more than 125 percent―represented a market climax fueled by one-time boosts to after-tax corporate earnings that are unsustainable as a trajectory. The second was a realization that the worldwide economic growth has been attenuated, and businesses face a less robust outlook for earnings in the decade ahead.

Tariffs & T-Bills

The fourth element discussed here a year ago was the flattening of the yield curve. That trend has proceeded along the lines anticipated. While the 10-year Treasury (at 2.72 percent) offered about the same yield on Jan. 29, 2019, as it had a year previously, the yield on the three-month T-bill had moved up to 2.42 percent from 1.44 percent 12 months earlier. Thus, the spread between the two maturities had narrowed to 30 basis points from 126 bps. That compression in the yield curve almost infallibly presages an actual inversion (with short interest rates rising above long rates). And an inverted yield curve is a reliable recession indicator.

The final risk, potential sudden disruptions with rippling impacts, are if anything more pressing today than in 2018. Already we’ve had a government shutdown of unprecedented length cost the economy at least $11 billion and perhaps more if the private sector reacts by increasing the price of uncertainty. Increasingly, a “no deal Brexit” seems probable, sapping the European economy. Tariff policy is impacting U.S. manufacturing costs and agricultural trade flows, and the prospects for escalating U.S.―China tensions are discouraging. The exposure of U.S. businesses and basic infrastructure to cybersecurity disruption is highlighted to an alarming degree in the U.S. intelligence community’s 2019 Worldwide Threat Assessment, a document that should be required reading for all business decision-makers.

Perhaps, though, the most significant item I’d like to underscore is that the very allusion to the late-cycle syndrome suggests that, following a recession, we will inevitably “get back to normal.” Normal, in this view, is the growth pattern of the economy in the most recent upcycle. But the odds are that the 2020s will see growth at a mere fraction―around one-half―of the expansion following the Global Financial Crisis. Are the real estate markets prepared for that kind of lengthy slowdown in demand? I suspect not.

In the words of Curtis Mayfield, “People, get ready.”

Read the March 2019 issue of CPE.