Outlook 2020: US commercial real estate
- We expect low rates, a strong US consumer, and balanced supply to continue to support commercial real estate in 2020, albeit with some idiosyncratic risks.
- Differentiation - particularly identifying “winning cities” - will be the primary source of stable income and protection from overvaluation concerns.
- This can help investors navigate valuation concerns surrounding many property types in “Big 6” markets (Boston, New York, Washington DC, Chicago, San Francisco, and Los Angeles).
US commercial real estate was supported in 2019 by a healthy labour market, balanced fundamentals and accommodative policy from global central banks. While concerns exist around global economic growth, the US economy has performed well and remains supported by a healthy US consumer, which has benefitted from strong labor market conditions.
Meanwhile, with only a few exceptions, supply/demand dynamics in commercial real estate have remained balanced . This has led to low vacancy rates and positive rent growth across retail, office, apartment and industrial property types.
It is our view that these conditions will remain in place in 2020, supporting the ongoing commercial real estate cycle expansion. That said, we are keeping a watchful eye on national affordability concerns and idiosyncratic risks, which we expect will prove meaningful to market and property type performance.
The big theme - moving from big to small
Low global interest rates have forced many investors to search for yield. With the US economy providing better economic growth than many other global markets, US commercial real estate has been targeted by investors, both domestic and foreign. This is evident in the record amount of capital raised for closed-end private real estate, year-to–date, of $334 billion.1
In addition, since the financial crisis, bank lending for real estate and infrastructure projects has fallen due to regulatory restrictions on balance sheets. The subsequent increase in debt funds as funding across the commercial real estate lending landscape - 11% as of H1 2019 versus 6% over the same period of 2017 - has introduced a competitive dynamic that prioritizes capital deployment efficiency. This, in turn, increases the focus on larger sized loans. We would trade the efficiency of capital deployment in larger loans for more appropriate risk pricing and covenant protection, that we can find in loans less than $25 million in size.
The search for yield, easier access to capital through competitive lending, combined with record dry powder for real estate investment, have caused concern for valuations of many property types in “Big 6” markets (Boston, New York, Washington DC, Chicago, San Francisco, and Los Angeles). Each of these markets has far exceeded their prior cycle peaks. This was a primary theme influencing our view on the US commercial real estate markets in 2019. Based on these dynamics, we believe the commercial real estate markets outside of the Big 6 should be the focus of capital deployment for investors in 2020. Schroders scores other major markets highly within our z-score model.
Ditching the six?
In 2019, we observed a number of news headlines pointing to concerns facing commercial real estate that we believe will continue to be influential in 2020. The lack of affordable housing is causing migration out of the Big 6 major markets, but it is also influencing corporate investment decisions. One need only look at the Amazon HQ2 move from Long Island City in favor of Virginia and Nashville, JPMorgan growing its second largest presence in Dallas, and Apple’s announcement of a second campus in Austin, TX. Cities located outside the Big 6 are positioned to benefit from this economic development and “in-migration” forming the foundation for long-term sustainable property cashflows.
Other noted concerns include retail (mall) risk, as well as idiosyncratic tenant risk (see in-store closures and problems with companies such as Wework). We expect that any credit risks to commercial real estate performance in 2020 will be idiosyncratic in nature, as broader fundamentals are generally healthy. While the rework of WeWork was a 2019 story, we expect the limited fallout will likely unfold in 2020 impacting only the office properties owned or occupied by WeWork and immediate surrounding locations.
Retail will, we expect, continue to see disperse performance. Obsolete regional mall properties are likely to continue to wither. Retail properties with more service and/or experiential oriented tenants meanwhile, like gyms, grocery/drug stores, medical services, restaurants, etc. should thrive. Large format industrial properties will continue to be a target for institutional buyers as demand for e-commerce grows. Market-rate apartments in growth cities will likely outperform luxury in the Big 6, which are still absorbing new construction inventory.
Putting it into focus with ”winning cities”
Differentiation will be key in 2020, with property markets outside of the Big 6 providing the primary source of stable income growth and protection from overvaluation concerns. Performance differences will be driven, in large part, by migration and demographic trends and corporate economic development combined with existing positive commercial real estate fundamentals (rent growth, occupancy rates, net absorption). These factors will allow investors to identify “winning cities”.
Within these markets, banks have been the traditional lender of choice. Since the financial crisis, regulation has limited bank balance sheet exposure and overall leverage on commercial real estate loans, thus preventing re-leveraging in these markets, leaving these markets stronger and less leveraged, with attractive price-per-square-foot metrics.
In 2020, commercial real estate will continue to build on the fundamental dynamics of 2019, assisted by accommodative global interest rate policies. We believe that investors will need to differentiate within their portfolios to avoid valuation concerns through selection of winning cities where healthy property fundamentals benefit from diverse and growing local economies, and an active commercial real estate investor base.