FOUR MAJOR COMMERCIAL REAL ESTATE SECTORS EXPERIENCED POSITIVE RENT GROWTH

Now that all the 1Q17 real estate and economic data has been posted and analyzed, it appears as though 2017 year to date is holding steady. All four major sectors experienced positive rent growth in the first quarter according to Reis, Inc. as apartments were up

0.2%, office was up 0.4%, industrial was up 0.6%, and retail was up 0.4%. These growth rates are slower than similar first quarters in recent years, but they still represent growing market demand levels. According to data from the National Council of Real Estate Investment Fiduciaries Pricing, growth and appreciation slowed and the index was up 1.5% in 1Q17. CoStar, who’s equally-weighted national price index grew 4.8%. In regards to overall pricing performance smaller properties are dominating larger ones. The CoStar value-weighted index, which is dominated by larger properties, fell -2.8% over the same time period. This trend has been growing since the start of the year.

NEW SUPPLY REMAINS WELL BELOW RATES

Many of those who are reviewing the slowing pricing data and overall rate of effective rent growth are asking “is this a top?”. The best is answer is to wait to draw any conclusions. New supply of nearly all property types remains well below rates and some are even close to having an oversupply. As a result, sustained declines in real estate pricing or net operating incomes are highly unlikely at this point. The employment market, which historically drives demand for commercial real estate, is as healthy as it has ever looked. The Bureau of Labor Statistics reports an official unemployment rate of 4.4% which matches pre-2008 recession lows. Further, the “underemployment rate” (known as U-6, which includes marginally attached workers and part-time workers seeking full-time employment) has fallen to 8.6%, which is also close to pre-recession lows. Optimism by business leaders has resulted in increased hiring which, according to the Conference Board, grew to the highest level since 2004 as measured by its CEO Confidence score which reached 68 in the first quarter. This score is up from 65 which was the score at the end of the year. (Any reading above 50 indicates optimism.) The survey results of CEOs reveal there is a continued desire to hire in 2017, but finding qualified workers may be a challenge.

ECONOMY POISED FOR GROWTH

The first quarter, which objectively was slower than 2016 readings, may not be indicative of the rest of 2017 and beyond. Arguably, the election result and corresponding rise in stock prices and interest rates was not forecast in 2016. As a result, it is possible that investment activity and price growth of commercial real estate slowed in 1Q17 for no better reason than buyers paused to assess what would happen to the capital markets given the changing landscape. While the new administration has yet to offer clear policy guidance, the overall assessment of the economy is that it is still poised and positioned for growth as of May 2017. In fact, many economists who predicted first quarter GDP would be slow, (the first reading was 0.7% growth according to the Bureau of Economic Analysis), have also predicted a late surge that could bring annual GDP growth to 2.5% or higher. This is why stock prices, and especially REIT prices, have remained relatively steady for most of 2017. The overall market is still optimistic and there is no reason change that view for commercial real estate.

Commercial Real Estate, Interest Rates, and the Federal Reserve

On September 20-21st the Federal Open Market Committee will meet and announce their decision on the target Federal Funds Rate and issue guidance on future changes. Given that the unemployment rate has remained stable and below 5% (4.9% as of the latest August report), hiring averaging above 200k per month for the long term, and inflation starting to read above 2% (2.1% annualized rate according to the Price Index of Personal Consumption Expenditures in the second quarter of ’16) it is widely believed that the Fed will resume raising its rate this September if economic conditions remain stable. The current target rate is 0.25-0.50% and any raise in this month is not likely to be more than 0.25%; however, the recent jobs report of only 151,000 (below the hypothetical 200k target to sustain growth) has led some to believe the rate hike will be paused to November.

A quarter point increase in and of itself is not likely to have any real significance to commercial real estate or other long-term assets; what will be impactful is the perceived stance of the Fed going forward with regard to the timing and magnitude of future rate increases. If the Fed postures that it must be aggressive in fighting inflation, then long-term interests will likely rise as could cap rates on investment real estate. This is not a very likely outcome of this FOMC meeting; the more likely outcome is a slight raise, or even deferment to the November meeting, with continued guarded measures to watch conditions unfold. With GDP growth averaging around 1%, it is hard to envision great fears about an “overheated” economy. Thus, it is not logical to expect much to change in the near term for commercial real estate, whatever the Fed may decide.

The Federal Reserve: Promoting Full Employment and Price Stability

To understand what the Fed is attempting to do, one must remember that they are said to operate on a “dual mandate” to promote full employment and price stability (i.e., keep inflation in check). At 4.9%, the US economy is theoretically at “full employment”, but given the slow rate of wage growth, small gains in productivity, and seemingly tenuous inconsistencies in hiring (May added only 24k new jobs) there is not a widely held view that the employment situation is healthy enough to sustain new economic shocks. Further, the unemployment rate that includes discouraged, marginally attached, and part-time workers who would prefer full-time employment stands at 9.7% (this is known as the U6 measure) which is above its hypothetical target of around 8% but drastically improved from its recessionary peak of 17.1% in December of ’09. Thus, the Fed has little motivation to “pump the breaks” and risk moving away from full employment.

Inflation and price stability is much trickier to assess. The Bureau of Economic Analysis produces the Price Index of Personal Consumption; as stated above its most recent reading is above 2%. The more commonly cited Census Bureau Consumer Price Index (CPI) is currently reading 0.8% annualized for all-items and 2.2% for all-items excluding food and energy. Overall, prices do not appear to be rising in totality, but certain areas such as Shelter, Transportation Services, and Medical Care are all growing at rates above 3%. If energy prices were to move upward, overall inflation could spike well above 3%. Thus, the Fed is pressured to “not wait too long”.

Impact on Commercial Real Estate

Commercial real estate has been in the winner’s circle for quite a few years, benefiting from high rent growth and simultaneously low interest rates and capital costs. Even low energy prices have a direct boost to net operating incomes of many commercial landlords. This dynamic is not poised to reverse itself in the short or even medium term. In fact, as fixed-income securities are much more at risk to interest rate spikes, more investment capital could move to CRE assets as a result of the Fed decision. In summation, real estate investors have little to worry about this round; but, it would be foolish to believe this low interest rate, high rent growth environment will last forever.

To learn more about the current CRE market and economic conditions throughout the U.S., read the 2016 Market Outlook Reports here.

[bctt tweet=”Real estate investors have little to worry about this round #CRE” username=”svnic”]

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Commercial Real Estate and the Economy Are Holding Steady in 2017