The commercial real estate industry has entered a time of solid fundamentals. Following the passage of tax reform, a consensus has reached an expectation of three percent annual GDP growth for the next three years. The concern a year ago regarding the market’s ability to absorb the maturing of CMBS issues, has so far, proven to be unfounded. Barring any seismic shifts in fundamentals, we expect CMBS refinancings to continually meet demand. Starting in 2022, however, some $70 - 90 billion is estimated to mature—a significant upswing from what we are seeing today. While that time horizon is too far forward to accurately predict how the market will react, it does present a potential vulnerability if there is a downward shift in valuations. 

Capital and operations

Commercial real estate enters 2018 with continued, solid fundamentals. Following the passage of tax reform, a consensus has reached an expectation of three percent annual GDP growth for the next three years. The concern a year ago concerning the market’s ability to absorb the maturing of commercial mortgage-backed securities (CMBS) issues has so far proven to be unfounded. Barring any seismic shifts in fundamentals, we expect CMBS refinancings to continually meet demand. Starting in 2022, however, some $70 - 90 billion is estimated to mature—a significant upswing from what we are seeing today. While that time horizon is too far forward to accurately predict how the market will react, it does present a potential vulnerability if there is a downward shift in valuations. 

We do expect further upward pressure in construction pricing, as resources are absorbed by public-private partnerships gearing up to tackle a backlog of infrastructure undertakings. While this development won’t be enough to dent the robust, ongoing pipeline of commercial real estate projects, it will provide an opportunity for developers with strong and efficient operations management and cost control capabilities to differentiate themselves.

Funds and fundraising

The year 2017 proved to be a strong one for real estate funds, and we expect that momentum to extend through the end of the decade. As has been the case in recent years, larger funds will continue to dominate both fundraising and deal flow. But increasing concerns about a possible stock market correction and the lack of other viable investment alternatives is nudging high net worth individuals and family offices into the market, providing a new source of investors for small and mid-sized funds. This is a particularly welcomed development for the latter group, given that they have had a challenging time distinguishing themselves from both the market pace setters and the smaller, more nimble boutiques. 

The challenge, of course, isn’t demand, but supply, as funds sit on record amounts of dry powder. While ready capital accelerates deal flow and boosts investment, it brings with it upward pressure on pricing that has the potential to lower returns. But there is a limit to what a market of disciplined investors will bear, and so we see valuations stabilizing in both primary and secondary markets. Similarly, we expect core transactions to be relatively few, with value-add continuing to offer the bulk of the opportunity to most outside investors. 

We expect debt funds to continue to attract investor interest, at least through 2018. Debt funds are active with acquisition, value-add, and transitional strategies, and are participating in first, as well as mezzanine positions, allowing sponsors to expand the capital stack.

Crowdfunding

Foreign investment

Last year turned out to be as strong a year for foreign investment as we expected, and we foresee 2018 continuing in much the same fashion, given that nothing has fundamentally changed the status of U.S. real estate as a safe haven for global investment. Sovereign wealth funds and foreign institutional investors have long participated fully at the top end of the market. What appears to be evolving, however, is a new level of activity and growing sophistication at entry-level and mid-sized investments. We are seeing the foreign family offices, high-net worth individuals, and smaller syndicates quickly move up the learning curve. 

How fast that learning curve is navigated depends on tapping into local knowledge. One family office we work with collaborated with a U.S.-based joint venture partner in 2016 to make its first industrial investments. Over the next 18 months, they accumulated a half-dozen properties concentrated in one region. Now, they are selling several to finance acquisitions of other types of properties in other markets. 

In a second example, a small foreign investment group hired a well-connected manager from a large U.S. real estate asset manager. The group’s expanded access allowed them to take part in four impressive deals in a six-month period, with more to come. 

The passage of tax reform in the closing days of 2017 created an even more favorable environment for inbound foreign capital. Because most foreign investors invest in U.S. real estate through corporations, the reduction of the corporate tax rate from 35 to 21 percent has made real estate that much more attractive. We expect to see some foreign investors currently in the market sell and reinvest, given that they will now hit their return benchmarks all the sooner— and that tax reform preserved 1031 exchanges for real estate. 

We expect multifamily and industrial continue to be favored among foreign investors, as these categories are affected by the fewest macroeconomic variables. To the extent that retail, hotels, and office attract foreign investment, it will likely be derived from the most sophisticated players at the top of the food chain.

Real estate technology

Among our commercial real estate clients, we noticed a technology-spending pullback in 2017 as compared to 2016’s enthusiastic shopping spree. But this may not indicate second thoughts on digital transformation. Instead, it is a predictable development on the path toward a more fully digital future. 

Consider that whenever there is any sort of technological revolution, the focus during the first wave of excitement is on the technology itself, acquiring it and learning how to use it. But then comes the more complex, granular phase of integrating these platforms into our lives, learning the capabilities, and letting the transformation actually proceed. 

We now are at the start of that second phase, digesting the profound changes that Big Data, analytics, and the Internet of Things are bringing to commercial real estate. Warehouses and distribution centers are now being designed not for people, but for robots. Rooftops are becoming solar farms. Hotels are creating high-end, app-driven retirement communities. These developments are much bigger—and require more than merely figuring out what type of software to buy. 

This new phase of technological transformation offers tremendous opportunity for the firms in and around the commercial real estate industry. (Construction, for example, has only scratched the surface of the disruption that is possible.) But seizing that opportunity will require three things:

Creating a Culture of Innovation: Investors, developers, operators, and others must create a culture of innovation, drawing upon a wider range of experience and ideas than had previously been the case. Two or three years ago, firms were content to essentially buy their innovation through software. Going forward, however, innovation must be something that commercial real estate firms do. This will require firm leaders who can foster collective creativity and allow for experimentation while still meeting performance targets.

Partnering Closely with Others in the Ecosystem: Firms need to partner more closely with others in their ecosystems. In an earlier day, real estate was primarily the business of providing square footage. But today, it is increasingly centered on utilization and experience. This shift makes the real estate firm more deeply entwined with the needs of the end user and those catering to him or her. The ability to help other players in the chain solve their challenges and meet their goals will be a powerful differentiator.

Managing the Transformation: Finally, firms in the commercial real estate space must be able to manage the transformation while running their businesses. The evolution of technology platforms, for example, means an ongoing reassessment of what to keep in-house and what to outsource. (Remember when companies maintained their own servers?) At a more strategic level, the need to take on new capabilities will drive changes in organizational design, personnel, and resource allocation. Firms that dominate the landscape 10 years from now will be those that best address these larger issues today, leveraging technological change to move past traditional boundaries and discover new ways of creating value.