Investors have plenty to celebrate this year on the economic front. The U.S. economy continued its nearly decade-long expansion and has been stronger lately than many people expected. Gross domestic product grew by more than 4 percent in second quarter 2018 — the highest rate in four years.
So why aren’t commercial real estate investors and lenders quite as bullish as they were a short time ago?
The reasons are many. The U.S. economy appears to be firing on all cylinders, but deal volume peaked in late 2015, and asset prices, while rising, are no longer growing at double-digit rates. Supply is a concern in some parts of the country, particularly in gateway markets, and rent growth has generally cooled, more or less tracking inflation. “Positive, but pedestrian rent growth” — of 1 percent to 2 percent — “will be the norm in many sectors,” according to Green Street Advisors’ Commercial Property Outlook for the second quarter.
THE END OF EXUBERANCE
By some accounts, a greater sense of normalcy is returning to commercial real estate now that interest rates are climbing from historical lows. In September, the Fed hiked its benchmark short-term interest rate for the eighth time since it began its normalizing policy in late 2015.
“In some respects, we are moving back to a more normal market,” says Jim Costello, senior vice president at Real Capital Analytics. “The only reason that deal volume was growing at double-digit rates every year — as prices were growing at the same time — is that the falling interest-rate environment made it easy for buyers and sellers to come together on expectations. It was a kind of unnatural period.”
How is the new normal — or rather, a return to the old normal — changing the calculus for investors? And with a greater sense of trepidation in the air, what property types and geographic areas are attracting capital flows from institutional and private investors?
Among other things, the once-sleepy industrial sector has become a darling of investors. In what may be the homestretch of the current real estate cycle, industrial is outperforming many other sectors, largely because it is benefitting from one of the biggest disruptive forces of our time: e-commerce.
And we are not only talking about the rise of Amazon.com Inc. Many traditional retailers are investing heavily in their e-commerce platforms, contributing to robust demand for warehouse and distribution facilities, especially those near major cities. E-commerce sales, according to Green Street, are growing at a much faster pace than sales tied to brick-and-mortar stores and will continue to do so over the next several years.
Despite a high level of development activity, the industrial sector’s vacancy rate stood at less than 5 percent in the second quarter of this year, a historical low, according to a JLL report. Annualized rent growth was slightly more than 6 percent — or more than twice the rate of inflation.
Strong transaction activity — driven by institutional investors’ acquisitions of entire companies and portfolios — has generally pushed up industrial property values, which rose by 11 percent during the 12 months ended in the third quarter, according to Green Street.
In some of the country’s tightest markets, such as Los Angeles and Seattle, industrial properties are now fetching nearly as much as office properties on a square-footage basis — narrowing what has long been a wide pricing gap between the two asset classes, says Tim Lee, vice president of corporate development and legal affairs at Olive Hill Group, a Los Angeles–based commercial real estate investment firm.
“Industrial is still very hot. Prices are coming up close to office asking prices. There has always been a huge gap in prices per square foot” between the two sectors, says Lee.
REDISCOVERING THE BURBS
As the cycle matures, investors are also turning their attention to suburban office properties — an asset class some assumed, in the years following the global financial crisis, might never make a full comeback.
In the post-recession era, investors largely favored office buildings in central business districts, in part because they believed those assets would benefit disproportionately from the millennial generation’s oft-reported penchant for living and working in urban areas.
During the past year, overall deal volume has declined in the office sector, with fundamentals generally “uninspiring as [landlord] concessions remain high and demand growth tepid,” according to Green Street’s Commercial Property Outlook for the second quarter.
Yet single-asset sales of suburban office buildings are still at record-high volumes, and they are well above the pace of activity at the peak of the last cycle in 2007, according to Costello of Real Capital Analytics.
“I thought the suburbs were dead,” he quips.
The simplest explanation, he said, is investors are pursing higher yields in the burbs. But Costello believes there’s more to the story: Namely, a growing number of young adults are heading to the suburbs, and employers are keen to be near talent, which bodes well for demand.
“Early in the cycle, it was all about wanting to own CBD office buildings because millennials are moving to the city, and they want to live, work and play” in urban markets, says Costello.
“We’re 10 years from the last [financial] crisis, and a lot has changed along the way. One predictable thing that happened is everybody got older, and some [millennials] are starting to pair up and move to the suburbs,” he added.
A Brookings Institution study released earlier this year found 2012 was the peak of the “back to the city” movement in the United States. Since then, suburbanization has picked up, as has a movement to rural areas and Snow Belt–to–Sun Belt population shifts, according to the study, which analyzed census data. The trend, however, notes Costello, “doesn’t mean that everything in the suburbs is suddenly golden.”
Little appetite exists, he explains, for the 1980s-era “vintage” office building sitting at the end of an isolated cul-de-sac. But office buildings in what Costello calls “pockets of urbanity in the suburbs” — highly walkable neighborhoods with public-transportation options, shops and restaurants — have seen strong price appreciation, he said.
APARTMENTS BACK IN FOCUS
The search for yield is also renewing investor interest in multifamily properties. Apartments are among the most-attractive sectors for private-market investors, according to Green Street, which reports strong job creation is keeping rents growing in the face of supply pressures in many markets.
“The reason we see a lot of interest in multifamily is that investors can get yield,” says Adam Hooper, co-founder and CEO of RealCrowd, a commercial real estate crowdfunding platform. “There are few options right now where investors can get consistent, healthy cash flow.”
Class B multifamily properties are particularly attractive, notes Hooper, partly due to relatively limited supply. During the recent building boom, many developers have focused on more expensive class A buildings.
“We’ve seen a lot of value-add multifamily lately,” explains Hooper. “You can find assets that had been mismanaged, or the previous owner didn’t have the capital for upgrades,” and make improvements to properties that will benefit from continued strong rental demand.
To keep up with demand, the United States will need 4.6 million new apartment units by 2030, according to a 2016 study commissioned by the National Apartment Association and the National Multifamily Housing Council. The study found the apartment industry averaged 225,000 completions a year between 2011 and 2016 — falling short of the roughly 328,000 average yearly completions needed to meet demand.
To some extent, the renewed interest in the apartment sector represents a flight to safety, says Lee of Olive Hill Group. Prices in the sector rose by 4 percent during the 12-month period ended in the second quarter, reports Green Street.
“If we have a recession, companies can shrink down their office [space], but people still need a place to live,” he adds. “There’s still a strong appetite [among investors] for multifamily.”
California is a notable exception, Lee adds. Earlier this year, many would-be apartment investors were sitting on the sidelines, waiting to see the outcome on Proposition 10. If passed in November’s midterm election, the ballot initiative would allow cities and counties across the state to expand rent control.
NICHE SECTORS GET THEIR DUE
On a national level, many investors have already expanded their horizons beyond apartments and other core property sectors. After years of rising asset prices, investors now have a “greater appreciation” for so-called niche assets, says Cedrik Lachance, Green Street Advisors’ director of REIT research.
The trend is particularly evident in the public market, where REITs that own assets such as student housing, manufactured homes and storage facilities generally have been trading at a premium to their private-market asset values. The same cannot be said for REITs that own more-traditional property types, notes Lachance.
“When you look at real estate that has the biggest discounts to private asset values, it’s the core sectors. Most niche sectors have been trading at a premium to asset values,” he says.
“The public market,” adds Lachance, “is saying that prices are unduly inflated in sectors like office and much more palatable in historically noncore sectors.”
ADJUSTING TO THE NEW NORMAL
For private market investors, particularly those who are relatively new to commercial real estate, today’s market conditions take some getting used to, says Hooper of RealCrowd. That has meant coming to terms with less-robust return expectations and longer-term horizons for deals, which, ideally, will allow investors to ride out market fluctuations.
“The return expectation hasn’t kept pace with the reality of where the market is today,” he says. “There’s a mismatch between return expectations and the reality of where we are in the cycle.”
“The easier, value-add deals are fewer and far between,” adds Hooper. “You now have to look more closely at the [investment] manager, and how they’re approaching things differently” from the herd.
The smart money, says Larry Sullivan, president of Passco Cos., does not necessarily worry about what is happening today, or even tomorrow. Long-term investors, he says, should be thinking about trends — demographic and otherwise — that will drive real estate demand over the next decade. That’s the approach his Irvine, Calif.–based firm has taken since its founding in 1998.
WHO IS GENERATION Z?
Today, Sullivan and his colleagues are pondering such questions as: What attributes will come to define Generation Z — the demographic cohort following the millennials — and what are the implications for real estate demand?
Millennials, for instance, may be content to live in tiny spaces, but members of Generation Z (an estimated 70 million people) may prefer apartments that can accommodate workstations, he said. The number of self-employed workers in the United States is expected to rise dramatically in the coming years.
“It’s too early in the game to figure out what exactly this next renter cohort will want, but you have to start thinking about it,” says Sullivan.
“The smart money has to consider what trends will drive demand, so that the assets purchased today are still viable eight to 10 years from now,” he adds.
That kind of thinking led Passco — which shifted its focus 12 years ago from the retail sector to multifamily — to invest in the Southeast between 2006 and 2012. During that period, many other investors were focused on the two coasts. But Sullivan and his colleagues believed the Southeast was poised for strong population and job growth, driven by an influx of millennials as well as companies relocating from other regions owing to state-government incentives and other factors. His firm’s instincts proved right, says Sullivan.
“We were trying to figure out where to buy [apartment properties], and we landed on the Southeast, partly because the yields were higher. More importantly, we felt it was a part of the country that would explode with jobs and population growth,” he explains.
“We’ve harvested great gains from the investments we made between 2006 and 2012. We were smart — and we got lucky — to sense what we believed to be a demand curve and invest into it,” says Sullivan.
A HEARTLAND RENAISSANCE?
Passco is still bullish on the Southeast, but it is also keeping an eye on the Midwest, which might benefit from the Trump administration’s efforts to bring more manufacturing jobs back to the United States.
“The U.S. coasts are still strong because of the affinity of capital” for those markets, says Sullivan. But “the Midwest might have a renaissance of a certain nature,” he adds. “That is a more-risky curve, and it has longer to play out, but it’s interesting to watch.”
Anna Robaton is a freelance business journalist based in Portland, Ore.