“A reasonable year ahead” is how Calvin Schnure described the remainder of 2020 in the commercial real estate space, including for real estate investment trusts (REITs). Schnure is senior vice president in research and economic analysis at Nareit, which represents and advocates for REITs and publicly traded real estate companies. He was speaking as part of a Grant Thornton presentation, hosted by Grant Thornton’s Greg Ross, national managing partner, Construction, Real Estate & Hospitality, and Lorraine White, National Tax Leader, Construction, Real Estate & Hospitality.
Slowing from above-trend
Schnure began his talk by discussing the economy in general. Economic growth slowed in 2019 compared with 2018, “but it was slowing from an above-average pace,” he said. That pace resulted in large part from the boost that the Tax Cuts and Jobs Act of 2017 gave to the economy. The more recent slowdown was an adjustment to a more sustainable rate, he said. Schnure does not see the slowdown, or other indicators such as a decline in manufacturing output or a general slowing of GDP growth, as foreshadowing a major downturn.
Companies worry downturn has begun
In a December 2019 survey that Grant Thornton conducted of high-level executives (including CEOs and other C-suite professionals), 68% of respondents believe we are already in a recession or that one will start in the next 12 months. Responders were from public, private, for-profit and private-equity companies with annual revenue of $250M or more.
For an in-depth analysis of the U.S. economy, review insights from Grant Thornton’s economist, Diane Swonk. More information is found at The next recession will be different. Are you ready?
Commenting on the effects of trade wars, Schnure said trade policy needs a long-run solution, as embracing trade allows U.S. firms to export goods and consumers to benefit from imports. At the same time, he said, the United States has a different economy from a lot of European or Asian economies, in that it doesn’t rely as much on exports, which are less than 10% of the U.S. economy. Schnure believes that low rate will serve to buttress the United States.
Schnure described the country’s current expansion, the longest on record, as a “mature expansion” that could continue, while acknowledging that opinions on the subject vary.
“I can’t just say don’t worry about things in the headlines,” said Schnure. Yet he does not see signs that the economy is overheating or is overextended, which are typical warnings of a weakened economy.
Feds and the yield curve
The Federal Reserve reversed course on interest rates in 2019, moving downward, which Schnure described as a way to get rates back to a “neutral rate rather than one that would be stimulating the economy.” Schnure said the Fed’s purchase of long-term securities, bonds and Treasury notes after the 2008 financial crisis has acted to hold down long-term rates.
The Treasury yield curve inverted briefly, in September 2019. Such an inversion has long been associated with risk of a recession. “We did see the yield curve invert last spring, and it started moving even further into negative territory through the summer into fall,” Schnure said. “Then, lo and behold, we did not get a recession. In fact, the curve righted itself.”
Variables good for commercial real estate
More than 10 years beyond the financial crisis, three contributors to financial conditions are conducive for commercial real estate:
Supply versus demand
- Low inflation
- Low mortgage rates
- A solid amount of credit availability
Commercial construction starts have gone up, particularly for apartments, where demand has been rising steadily since 2012. (See “A snapshot of supply and demand in the apartment market,” below.) Industrial construction rose steadily in the past few years, driven largely by the need for logistic facilities used for shipping goods purchased on the internet. Schnure pointed out that most larger, undeveloped areas suitable to build these types of facilities, and to some extent build office buildings, have already been developed, and he gave the example of a REIT that has developed multilevel facilities as a way to accommodate need.
Office-building construction has held flat in the past few years, and retail has remained flat or dipped. Neither of the latter occurrences is a surprise, said Schnure, considering that the office-space model has changed with a move to an open-space office concept, and retail has faced numerous challenges from e-commerce.
Right now there is a rough balance between overall new construction and demand growth, said Schnure. “Supply and demand in all areas are relatively balanced.”
REITs are rolling, commercial values have moved up
REITs report rising earnings, with the percent of REITs with funds from operations (FFOs) increasing from over a year ago. (This is the calculation for FFOs: Net Income + Depreciation + Amortization - Gains on Sales of Property.) “Through the third quarter, about two-thirds of REITs were reporting higher earnings than they were a year ago,” said Schnure. The numbers coming in for the fourth quarter back this up, he said, and point to sustained expansion.
Said Schnure: “Earnings growth on REITs slowed from 2016 to 2018, raising yellow flags for some people. Yet we’ve seen rebound in the past year, and strong demand for REITs on properties.” REIT occupancy rates reached a record high at the end of 2018, and inched off a bit but are still close to record. “That’s consistent with saying commercial real estate and the publicly traded portion of the market are on solid ground.”
Although the residential housing market overall has weakened, commercial property valuations have moved steadily higher. Continuing to decline, to the lowest rates in a decade, were capitalization rates, which reflect the ratio of net operating income (NOI) to property asset value; for example, if a property sold for $1 million and had an NOI of $100,000, the cap rate would be $100,000/$1 million, or 10%. Low cap rates are normal in a low-interest-rate environment.
Schnure wrapped up his talk by highlighting a key point: Today’s commercial property market appears to have a risk-reward tradeoff in line with other periods in history.
“One of the biggest risks would be if the real estate markets were flooded with an unsustainable amount of construction, which we’re not seeing,” he said. “Another risk would be if we saw demand falling sharply. We’re not seeing that either. We did see a slowing of growth, which is like saying if you’re going 80 miles per hour on the highway and slow down to 55, you’re still getting closer to your destination; you’re still moving forward. We have a rough balance between supply and demand.” There are risks to watch, he said (debt growth, pricing, transaction volumes). “But right now there are none that I would call major concerns for the year or two ahead.”
For details on Schnure’s report on commercial real estate market and REITs, and a discussion of “tax hot topics for real estate,” replay
the Grant Thornton webcast.
A snapshot of supply and demand in the apartment market
The supply and demand for apartments has gone up since 2012, whereas the demand for single-family homes is not being met as demand continues to rise. This has led to questions about what this trend means. Calvin Schnure, senior vice president in research and economic analysis at Nareit, says this development has a kind of logic behind it. “There are a lot of concerns about affordability in the apartment markets, but an unusually large amount of construction starts are luxury apartments. So why are people building those if there’s an affordability problem?”
A key is a “cascade of demand” from single-family housing into the apartment market, from the newer, higher-quality and luxury apartments to the mid-quality level, he said. “To keep pace with population growth, we need about 1.25 million to 1.5 million homes and apartments built every year, and that’s fallen far short, particularly in single-family homes. So what you have is people who would have been first-time home buyers in previous housing markets renting apartments.” In fact, over the past decade the largest-growing type of household was among renter households with incomes over $100,000. “That’s why there is apartment construction and why it’s at the top end. Displaced homeowners, who would have been buying a home in this market, actually are large enough to absorb all the new luxury apartment construction.”
What this means going forward, he said, is that even with a lot of construction, there is still a backlog of demand, including people living with parents or roommates or other family members — about 3 million households. “So we could continue building at above-trend for many years without saturating the market.”
Not always rosy
Some analysts are expressing worries about the housing market in general, and about the “affordability” gap. Multifamily housing construction dragged on growth with a 7% year-over-year decline as of December 2019, said Grant Thornton’s Associate Economist Yelena Maleyev in a February column. Builders have turned to building more luxury apartment dwellings in recent years to combat the high costs of land and labor that are squeezing their margins. That has led to a rise in the number of renters who are cost-burdened, spending more than 30% of their income on rent.
For more on these figures and construction spending in the public and private space, see “Unseasonably warm weather not enough to lift construction.
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