Mixed signals in the U.S. economy and what it means for Commercial Real Estate

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Despite a double digit return in the US stock market in the first quarter of 2019 and against a backdrop of the FED taking a 180 degree turn from its 2018 stance which helped bolster market sentiment, certain economic indicators suggest the US may be at the later stage of an economic cycle.  According to research by Morgan Stanley in a segment labeled, “In Search of a Late-Cycle Safety Net”, earnings may start a downward drift of as much as 3% for the first quarter of 2019 YOY as a result of compressed margins which could in turn cause pressures that could lead to an economic downturn.   Furthermore, in research published by Goldman Sachs, Chief Credit Strategist Lotfi Karoui suggests the corporate credit markets, specifically BBB issuance, making up 50% of the market share of corporate investment grade debt, could be at risk for a downgrade if a substantial shock to earnings were to occur.  That being said, Karoui seems to assign a low probability of that scenario happening over a short time horizon or all at once given the current economic backdrop. He further mentions Commercial Real Estate specifically having an overheated valuation across asset classes in the current economic cycle. It’s important to note that many of the concerns expressed by credit investors are related to events which are yet to take place or are happening at a pace that is not yet a cause for immediate concern.  The message seems to be that 2019 should still be a relatively stable year for the US economy but that it is important to heed some of the factors that could eventually have an impact on the overall economy and eventually the commercial real estate segment.

Recent trends in the Commercial Real Estate space seem to indicate that both investors and developers are signaling an understanding of the late cycle nature of the US economy.  Among those trends have been the emergence of apartment projects coming online in many primary and secondary markets despite a nationwide shortage of housing in many cities*. According to an article published by Dean Jones of Realogics Sotheby’s International Realty, many developers with recent memories of the 2008/2009 real estate recession are taking the path of least resistance.  Many of these projects were originally programmed as Multi-Family Condo projects and later converted to Apartment projects as a result. Among the factors contributing to this shift are rising lending costs for condo developments, higher equity contribution requirements and higher insurance costs as compared to apartment projects, all factors pricing in higher risk premiums given the potential for defaults.  In addition, having the ability to have income as an offset to market price volatility allows many developers to wait until the right moment to convert to condo projects and earn income and service debt more easily. According to the Urban Land Institute in their 2018 “Emerging Trends in the Real Estate Market” report, Apartment development projects are the best investment market in the Commercial Real Estate Space.  This trend is further catalyzed by the “Work and Play” mentality driven by millennial demand to rent in urban markets. The re-urbanization movement has prompted a focus on amenities and socially responsible living versus the “American Dream” of home ownership. This may be further prompted by a generational reality of the negative effects of the last economic recession prompted by a housing bubble adversely altering the psyche of the newest generation of entrants into the real estate market.

An additional by-product of this trend is the growth and reliance on e-commerce for everyday life which has had its own signature on retail and industrial asset classes.  While brick and mortar is not obsolete, demand has helped morph the retail and industrial asset classes to be more sensitive to an ever changing landscape. According to JP Morgan, “last mile” industrial repurposing of industrial sites in distribution centric locations is occurring across the map.  Retail space across the nation is being converted to light industrial warehousing sites to accommodate e-commerce and digital purchasing platforms which act as delivery hubs for major centers. The idea is to maintain close proximities to major urban centers and act as a decentralized distribution channel for B to C consumption.

Though the cautionary tale is for developers and investors not to repeat the mistakes of the past, many investors are still on the hunt for real estate opportunities.  Some markets represent a good opportunity for the investors with a longer time horizon. According to a report by GoBankingRates, there are a number of cities that are more likely to see delinquency and foreclosure rates go up in the next year.  In their report, they ranked the top 40 cities likely to see declines. Among some of the top cities in the report, Miami, Florida and Chicago, Illinois were listed. Not surprisingly, many investors and developers in both cities have made recent shifts to core income assets including apartments, student housing, triple net leased commercial and light industrial warehousing so as to diversify their portfolios and avoid the volatility that may be lurking around the corner.  Developers in Miami were among some of the worst hit in the nation during the 2008/2009 crisis and memories are still fresh for most of the folks on the Suncoast. Nevertheless, for the right type of investor, these cities represent an opportunity to absorb inventory in the near future at distressed levels and repeat the cycle of 2009 which saw an abundance of vacant inventory only to be snatched up by opportunistic investors, mainly European and Latin American investors looking to diversify their portfolios to hedge against currency and in some cases political risk in their own respective countries.

In conclusion, 2019 is poised to be a strong year for Commercial Real Estate across most asset classes, but there are clouds on the horizon and lenders, investors and developers alike are heeding the warning signs and making defensive shifts to reposition their portfolios to weather any potential storm.

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