Prosperity continues in 2017, but the cycle is heading toward a fall
By Kenneth P. Riggs Jr., CCIM, CRE, MAI, FRICS | Jan.Feb.17
The upward momentum that commercial real estate prices and values have been experiencing has recently slowed relative to their appreciation trajectory since their amazing recovery starting two years after the credit crisis. Given the challenges in today’s world and the many dynamics affecting commercial real estate, the economy, and the financial markets, it is time to fully understand the next phase of the current market cycle.
As the transition moves to this next phase, it is time to examine the key forces that will dictate one of the following:
market correction; or
major market correction or crisis.
All investors, including commercial real estate investors, are focused on when is the end of this phase of the cycle; what will be the triggers that push the industry into the new era; and what should commercial real estate professionals expect for value and price changes.
Looking back, commercial real estate has been a stellar investment performer and a preferred asset class since shortly after the credit crisis. This continues as institutional investors consider commercial real estate as the top investment alternative.
It is a real asset, offers strong income, and has matured as an asset class. As shown in Exhibit 1, the strength of this confidence in commercial real estate and stocks has declined from peak levels of a few years ago, while investor confidence in cash has grown and confidence in bonds remains relatively low. This pattern signals that a market turn is around the corner but not how far out.
Commercial real estate looks like the best investment choice, and the rationale stills holds true. Investor focus must be in preparing for the next phase and determining when it will turn.
Situs RERC recently polled real estate professionals at the 10th annual University of Chicago Booth School of Business Real Estate Conference about where the industry is in the current cycle. Using a baseball analogy to compare the results of this real time poll and Situs RERC’s view, commercial real estate is in the bottom of the eighth inning at the end of 2016 and will enter the ninth inning in 2017.
The year 2017 is expected to be much like 2016, with commercial real estate prices and values on average increasing sluggishly and cap rate compression stalling. Like the final game of the 2016 World Series, the industry will go into extra endings due to the influences and forces that evolved since the Great Recession and through the transition into the next era. At some point, the extra innings will end and the game will be over. Just as in baseball, it is difficult to tell how many extra innings will be played to usher in the next phase of the cycle.
If this is the case, examination of the final script and the players that will deliver that conclusion. In the commercial real estate investment game, other influences and forces will determine the end of this stellar performance.
Looking to 2017 and beyond, the risk factors facing the economy, the investment environment, and commercial real estate are considerable. The Federal Reserve has clearly called the plays and influenced the key aspects of the economy, interest rates, and financial markets. The Fed’s future decisions will also influence the next cycle, as its members will have to eventually increase short-term interest rates.
In a surprising turn of events that stymied the pollsters, Donald J. Trump was elected president. After a campaign fraught with acrimonious rhetoric, the president-elect’s tone and tenor has changed. Although the election brings uncertainty, this uncertainty appears to be positive for investment, at least for now.
Typically, what is good for the economy is good for commercial real estate. Mr. Trump’s proposed pro-growth fiscal policies, however, have stoked inflation worries, sending Treasury rates upward.
The cap rate compression during the past few years has been driven by a low interest rate environment. If interest rates rise too quickly, commercial real estate may not be able to absorb the impact. Only time will tell whether President Trump’s policies come to pass, but since commercial real estate tends to lag economic trends by at least six months, commercial real estate growth in 2017 will likely hold steady.
Also, potential black swan events could lead to a major market correction. Although it is tempting to believe there is a nice script of events that will happen in sequence smoothly and predictably during this next cycle, not everything goes as planned. This is true especially since the new set of players has not experienced these kinds of events since the Great Recession.
It is all new and the economy will reach a normalized level, but there will be ups and downs. The question is, how volatile will the transition be for commercial real estate?
Most important for the industry is the reality that the Fed will raise short-term interest rates several times throughout 2017. The primary driver of low long-term interest rates has been the Fed’s low rates, a sluggish economy, and low inflation. Commercial real estate investment lives on debt to the tune of 50 percent or higher and remains one of the most leveraged asset classes.
As a result, the industry has been one of the biggest beneficiaries of this historical low interest rate environment that has pushed cap rate compression to a new level. Now the Fed is playing the waiting game with rate hikes since economic conditions have continued to improve. Situs RERC’s expectation is that a series of interest rate increases is on the horizon.
Although it is likely that the Fed will continue to raise interest rates in 2017, rates are still at historical lows for the major global economies (see Exhibit 2). While central banks are trying to fight their country’s respective economic problems, the negative impact of this uncertainty is felt in the U.S. In fact, the Federal Open Market Committee hesitated to raise rates in 2016 in part due to unanswered questions of global growth amid speculation about the impact of Brexit.