2018 Commercial Real Estate Outlook: Market Sectors
Each commercial real estate sector has its own contours and nuances for the current market. The extent to which the boundaries between sectors continue to blur (except for home building and development, which has its own powerful set of dynamics). Hotel chains explore building high-amenity multifamily housing for boomers, underused retail space is reborn either as work/play/live communities or as retail-industrial combinations, and traditional office space converts to multifamily and/or flexible co-working space.
With valuations high and little room for further cap rate compression, investment-driven deals have given way to the search for current income and appreciation. Revitalized urban centers of gateway cities continue to attract the largest investors, while everyone else remains focused on secondary and tertiary markets, along with high-amenity suburban transit hubs.
As we describe below, each sector has its own contours and nuances for the current market. It is interesting to note the extent to which the boundaries between sectors continue to blur (except for home building and development, which has its own powerful set of dynamics). Hotel chains explore building high-amenity multifamily housing for boomers, underused retail space is reborn either as work/ play/live communities or as retail-industrial combinations, and traditional office space converts to multifamily and/or flexible co-working space. We expect this reshuffling of the nation’s real estate stock to continue for some time, providing opportunity to those who can best translate large-scale social trends into innovative real estate strategies.
Home building and development
In home building and residential land development, as with so much else in commercial real estate, demographics is destiny. Millennials are discovering that when it comes to raising families, single-family homes have advantages over the most amenity-filled apartment complexes—especially once the second child comes along. This newfound awareness, combined with rental rates that have seemingly reached what the market can bear, is pushing those millennials with down payments (or access to the “Bank of the Folks”) off the sidelines and into the homebuying market. However, they are often bringing their amenities-filled expectations with them. Just as millennials have reshaped the multifamily sector during the past decade, the homebuilding market must now respond by creating inventory suited to their very specific tastes. Add in the downsizing of baby boomers into active-lifestyle communities, and we fully expect the demand for new housing to stay strong throughout 2018 and beyond.
Unfortunately, developers face substantial challenges in pursuit of some opportunities. Entitled lots in desired markets at reasonable prices are becoming increasingly scarce. Municipal governments, faced with the need to grow revenues, have aggressively transformed permit processes into cash cows. Construction funding from traditional lending sources is hard to come by, given the constraints of Basel III on large lenders and the restrictions of loan limits on community banks. Private equity is increasingly reluctant to take equity stakes in development projects given the durational risk present at this point of extended economic growth. And while private equity is more than willing to provide debt and interest rates have indeed remained highly stabilized, the debt comes at a hefty premium.
For privately-held developers, this confluence of forces means that success is dependent on two factors. First, developers need to be nimble, relying on local market insight and speed. Second, given that they are likely to have a higher cost of capital than their publicly-held counterparts, private developers must be masters at project management and cost control to compete effectively.
These requirements are eminently achievable. Nonetheless, challenges faced by privately-held builders and developers will broaden industry consolidation. Private firms, after all, are attractive targets for U.S. publicly-held builders and developers, who often find acquiring a firm with a favorable land position to be cheaper than trying to create an equivalent position on the open market. Private firms also are attractive to foreign buyers, especially Japanese developers, who have been taking a more aggressive stake in the U.S. market in search of opportunities beyond Japan’s own contracting economy (and in so doing, picking up the slack left in the wake of China’s recent retreat).
But public firms are not only potential acquirers—they are possible targets. Lennar’s acquisition of CalAtlantic, itself the product of a merger, is a vivid recent reminder of this fact. Even among the largest firms, the U.S. homebuilding industry is highly decentralized. Consider that the market caps of the top 25 homebuilders stretches from almost $20 billion all the way down to about $250 million—a nearly 70-fold spread. We expect 2018 to be a highly dynamic year—both in terms of what’s taking place on the ground, and behind the scenes.
Retail and industrialThese two components continue to be intertwined, as retail grapples with finding the optimal strategy for blending the brick-and-mortar and online experiences and infrastructure in a way that best meets the consumer’s rising convenience expectations. The consumer may want to order online and pick up at the store, or browse at the store and order online, or remain exclusively online and only go to the store for returns. Accommodating this range of demands and evolving shopping trends requires greater numbers of smaller distribution hubs into urban centers. So it is that we are seeing shopping centers repurposed into combined retail/ industrial stores and warehouses. Some B- and C-class malls are being entirely converted into distribution facilities. But if retail and industrial are intertwined, industrial is clearly in the driver’s seat, with the market as hot as it has been in recent memory.
Viewed from a high level, multifamily is poised to continue its spectacular run. But from a granular level, considerable complexities emerge. Millennials are beginning the shift from apartment living to homebuying. But this shift is unfolding in fits and starts. For many in this generation, the down payment remains a formidable barrier to homeownership. Downsizing Boomers are also increasing demand. These two forces, along with record low unemployment and a thriving economy, are enough to keep the multifamily sector healthy in most areas— although topping out of rents in major markets along with a slowing of absorption rates shows that there are limits to the returns investors can expect. A significant complexity is that the lion’s share of demand will be for affordable workforce housing, i.e., contemporary versions of the garden-style apartments built during the post- war years for the rapidly expanding families that produced the baby-boom generation. But this class of housing does not have the investor appeal of high-tech work/live/play environments. However, more tempered return expectations, professionalized operations that can control costs and new business models—or some combination of the three—may emerge to nudge investors in this direction.
The possibility of new business models for multifamily is more than idle speculation. We’ve heard talk of applying the Airbnb model to housing, creating apartment complexes that combine short-term and longer-term living situations. Regardless of the specifics, it is more than reasonable to expect a rethinking of housing in the same way that car ownership has given rise to more fluid “mobility solutions.”
Hospitality industry observers—us among them—have been expecting supply to catch up to demand in early 2018, and indeed, we start the year having reached that equilibrium. In previous years, operators were able to turn to rate increases to grow profits, but with inflation now forecast at 2.0 - 2.5 percent and labor costs undergoing continued upward pressure, there’s little chance that rate increases will filter down to the bottom line.
This combination of factors signals an important shift in the market. Yes, there is still opportunity. But rather than a rising tide lifting all boats, we enter a zero-sum game. If occupancy rates are flat and inflation and rising costs eat rate increases, the only way to grow is by winning over your competitors’ customers. Sales, marketing, and data-ana¬lytics capabilities thus become the key differentiators in a highly competitive market. Moreover, competition will be fierce given that it will be focused on a particular segment— the baby-boomer leisure traveler. There’s much less room for movement among mid-week business travelers, given corporate contracts, loyalty programs and the desire for predictability among that group.
Thinner margins haven’t done much to dampen development. Whether or not this signals a disconnect with the market depends on the overall economy. If GDP, unemployment, and other key indicators remain positive, there’s a good chance that a gradual, but steady, rise in supply will be matched by a similar uptick in demand. But an economic downturn would only make an already competitive environment that much more intense.
As the current post-recession economic boom reaches its five-year mark, the possibility—indeed, the inevitability—of such a downturn is certainly on everyone’s mind. Foreign investors, for example, pulled back from the sector and are looking elsewhere, such as multifamily, for safe-haven real estate opportunities. Conversely, investment from domestic funds continues to be strong. It’s worth noting that enthusiasm needs to be backed by skin in the game, given that most traditional lenders still won’t move above a 65 percent loan-to-value ratio.With valuations high and little room for further cap rate compression, investment-driven deals have given way to the search for current income and appreciation. Revitalized urban centers of gateway cities continue to attract the largest investors, while everyone else remains focused on secondary and tertiary markets, along with high-amenity suburban transit hubs. We expect a reshuffling of the nation’s real estate stock to continue for some time, providing opportunity to those who can best translate large-scale social trends into innovative real estate strategies.
Subject matter expertise
CPA, Partner, Chief Executive Officer
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