The commercial real estate (CRE) market heads into 2020 looking like a mirror image of the broader economy – still healthy but moderating, with wider dispersion between sectors becoming apparent. Our outlook for Q1 2020 calls for a continuation of this trajectory, with property price growth resuming its moderation after receiving a momentary shot in the arm from lower interest rates.
Macro backdrop: not that bad is good
The fundamental economic landscape has soured somewhat over the past 18 months, with year-over-year GDP growth in the U.S. falling from a peak of 3.2% to 2.1% currently. We expect growth to continue on this path and settle in around 1.7% in 2020, a slowdown that would be uncomfortable but not catastrophic. Globally, activity has declined more sharply, with the U.K. and Germany posting negative growth in Q2 and China continuing to slow.
In the U.S., property demand is buttressed by a strong labor market, which continues to support steady consumption growth. Historically low unemployment and rising wages have helped push national vacancy rates to multidecade lows, while strong personal consumption continues to drive healthy rent growth. Business investment represents the other side of the growth coin. Weakness in structures investment has been particularly apparent, which has helped keep property supply moderate and supported price growth.
Capital markets: owing a debt of gratitude
Transaction volume in 2019 is on pace to finish 10% lower than 2018, as a dearth of larger entity-level deals has impacted headline numbers. However, underlying demand for individual properties remains robust and has kept up with new supply. Property prices have received a boost from lower interest rates and rose 8.7% year-over-year through November.1 Lower rates have also reduced upward pressure on cap rates, as spreads between the 10-year Treasury and property yields have closed in on cycle averages. We expect price appreciation to continue to be driven by rent growth, with little to no contribution from cap rate compression.
CRE debt markets continue to promote strong demand for property by offering attractive financing. Mortgage rates hit a cycle low of 3.9% as of October 31, widening the spread between cost of debt and property yields, a measure that has historically been positively correlated to overall transaction volume. CMBS issuance hit a post-crisis high in 2019, driven by strong apartment volume, and CRE CLOs continued to gain traction. Debt markets remain open, robust and competitive, with alternative lenders continuing to gain market share. However, metrics still show a disciplined market, with lenders willing to compete on pricing rather than structure.
Property types: going their separate ways
As the current real estate cycle enters its second decade, a performance disparity has grown between different property types. As valuations have reached higher and higher, fundamentals of individual sectors are becoming increasingly important to investors. The delta between the best-performing and worst-performing property types averaged 5% from 2010 through 2017; today that gap is over 12%, the highest since 2005.2 Differences within sectors have also become apparent, including between commercial business district (CBD) and suburban offices. While elevated dispersion has at times signaled a downturn for the space, we see it as more representative of diverging secular trends.
The increased dispersion initially coincided with the tightening of monetary policy, which started in late 2015. Monetary stimulus tends to act as a “rising tide that lifts all ships,” and that is precisely what we saw during the first half of the last decade. Indeed, as the Fed cut rates three times in 2019, a similar effect can be seen: price growth increased across the board going into year-end. With the Fed now (allegedly) on hold, we would expect dispersion to remain and for individual sector fundamentals to drive returns once again.
Macro trends have favored the industrial sector, which has broken away from other property types over the past three years. The market for industrial assets remains strong, driven by the rapid growth of e-commerce and the associated demand for distribution and logistics centers. Meanwhile, although the retail sector faces a challenging structural backdrop and continues to trail other major sectors, it has seen a healthy uptick in price growth over the past few months.
1 Real Capital Analytics.
2 Macrobond; NCREIF Property Index.
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