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Commercial real estate healthy and balanced

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Commercial real estate healthy and balanced The red flags that usually precede an economic downturn are not present in the U.S. economy right now. In fact, consumer spending and business activity remain robust, household income has held steady and overall GDP spending is slowing from above-trend back to a more sustainable pace. Economic and job growth - both fundamentals for real estate - are also secure.

Such were the takeaways from a Grant Thornton-sponsored webinar on the commercial real estate sector led by Calvin Schnure, senior vice president of research and economic analysis at Nareit, a national association that represents the real estate investment trust (REIT) industry. Hosts were Greg Ross, Grant Thornton national managing partner, Construction, Real Estate & Hospitality, and Lorraine White, Grant Thornton national tax leader, Construction, Real Estate & Hospitality.

“The consumer sector is on fairly solid ground,” said Schnure. “The consumer has healed a lot since the financial crisis.” That confidence has contributed to a healthy commercial real estate sector.

At the same time, Schnure does believe economic activity will slow in 2019, after ramping up a bit in 2018. “The effects of the tax cut are fading, and the economy will continue slowing into this year,” he said. Yet he sees no risks associated with a macroeconomic tumble.

Economic growth continues, but how long? It’s difficult to predict precisely how long the economy will continue its upward movement. “Think of it as a fifth set at Wimbledon without a tie break,” said Schnure, referring to a “match” that can go on without an obvious ending. Reasons to worry stem from overbuilding, overheating and overleveraging. “And I am not seeing any of those indicators.”

Job market creates room for economy to run One of the key features to look at when appraising the potential upsides for the overall economy is the labor force participation rate, that is, people either currently working or actively looking for a job. The participation rate for those aged 16 to 64 (i.e., prime working ages) plummeted during the financial crisis, but has been recovering gradually. Despite a low unemployment rate, the recovery of the participation rate “says there are a lot of people who are working age who might be in school, caring for parents or children, or not looking for jobs, given the wages they could get,” Schnure said.

He views the pool of prospective workers as positive for the labor market. “A lot of potential workers could come back and take a job as the market strengthens. This gives us more room for the economy to run.”

Commercial real estate healthy and balanced

Inflation – no overheating As far as inflation goes, Schnure is not overly concerned. “Early last year, inflation rose to around the Federal Reserve’s target [of 2%], so the economy was at risk of overheating,” he said. That was short-lived. Over the past six months, inflation has been running at 1.5%. “We are not seeing signs of an overheated economy.”

Contributing to low inflation are factors like soft wage growth, sufficient manufacturing capacity and corporate profit margins able to absorb increases in employment expenses.

Interest rates holding steady Schnure, who spent a decade working on the economic staff of the Federal Reserve, believes the Fed will pause interest rate hikes. Interest rates had been moving up from the below-normal rate the Fed put in place to help the economy heal after the Great Recession, he said. “Yet interest rates at this rate are not hurting real estate.” Even if rates did rise nominally, “the economy won’t crash and inflation won’t heat up.”

Treasury yield curve Yield on the 10-year Treasury note moved to 3% for the first time in five years, yet a longer-term view shows yields are still at the low end of their historic range. In fact, during two periods of sustained growth in a low-inflation environment (1963-­1969 and 1995-1999), the yield curve was consistently flatter than it is today. Said Schnure, “I am not worried about a flat yield curve.”

Balanced supply and demand Vacancy rates across the board in real estate have declined consistently in the past seven years, said Schnure, “which tells us that supply and demand are roughly balanced in major property types. We are balanced and not overbuilding.”

Commercial real estate healthy and balanced

Rent growth: Retail, office, multifamily Weakness in the retail space has weighed on the commercial real estate sector to a certain extent, with many bankruptcies and closures of big-box stores. Yet generally new tenants have moved into vacated spaces, said Schnure. “REITs have a large share of regional malls, and higher quality malls. People want to get into that space.”

The office sector also has slowed as it grapples with changes like shared work spaces and the spread of office-share arrangements. Rents there are still rising – a bit above inflation trends.

In the multifamily rental sector, apartment rents are still rising after slowing in 2016 and 2017 following a heavy increase in construction that temporarily flooded the market. Yet the vacancy rate went back down in 2018, when rent growth rose by about 3.5%.

The rental market has more space to grow. “Since the financial crisis, a lot of Americans doubled up with roommates or family, creating a shadow demand,” said Schnure. A main barrier to stronger rent growth has been a lack of affordability for many households, but that could change as the job market strengthens. “There is a strong wind in the sails for the apartment market, given the pent-up demand.”

REITs REITs own a significant chunk of investment-grade commercial real estate in the United States, and REITs have continued to have rising earnings. Earnings of listed equity REITs rose 11% over the previous year in 2018. In addition, the leverage ratio of REITs is the lowest it’s been in a decade, and interest rate exposures are at a record low. “REITs have reduced exposures to interest rates by raising more equity capital to debt, giving them a strong cushion,” said Schnure. “They took these smart measures to protect their balance sheets.”

Some other considerations
  • Brexit. Schnure described the impact of the current Brexit crisis on our economy as “more a speed bump than something bringing us to a full stop.” He does not believe it would become a major economic issue for the United States.
  • Trade wars. A potential trade war remains a wild card in the economic outlook, said Schnure. A trade war could bring the economy down some, “shave something off the top,” as he put it, yet he does not think that alone would cause the country to go into a downturn.

Contacts:

Gregory RossGreg Ross
Grant Thornton National Managing Partner
Construction, Real Estate & Hospitality
T +1 704 632 6817

Lorraine WhiteLorraine White
Grant Thornton National Tax Leader
Construction, Real Estate & Hospitality
T +1 215 814 1728