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5 Trends in Commercial Real Estate for 2017: Pt. 2

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The U.S. property market landscape in 2017 will be characterized by continued strong fundamentals, increased investor flows, and high transaction volume. As for the economic landscape, the U.S. continues to grow moderately and add jobs. U.S. employment gains continue to be strong, with unemployment dropping below 5 percent earlier last year, and adding to demand for commercial real estate in a variety of sectors. Many are surprised we have not reached the end of the current economic growth cycle. The fact that the recovery was so protracted and that growth relatively anemic over the last seven years leads me to believe that we may have another two years left in the current growth cycle. 

The U.S. Federal Reserve made it clear last December that the central bank sees U.S. growth as relatively stable, notching the federal funds rate higher by a quarter point in early December. This is only the second time since 2006 that the Fed has raised rates (the last time was in December 2015). “Economic growth has picked up since the middle of the year,” said Janet Yellen, the Fed’s chair. “We expect the economy will continue to perform well.” Nevertheless, underlying inflation is extremely tame in the United States and in major emerging markets (with worries of deflation in some sectors and countries), providing no impetus for significantly higher rates. Lending rates and fixed-income rates of return will still be very low by historical standards, inducing continued levered purchases of real estate assets.

These five trends will play a significant role in commercial real estate in 2017 (Trends 4-5 are presented here, with Trends 1-3 in Part 1):

4. Volatile Energy Markets

Energy market volatility has already affected certain regional U.S. economies (Houston, North Dakota) and producer nations (Saudi Arabia, Venezuela). 2015 saw a dramatic drop in oil prices, and the drop continued through the year, followed by substantial volatility through the year and prices rising in the last quarter of 2016. Increased production and reduced demand due to slowing global growth led to the decline which saw oil prices fall from 105.79 in June, 2014 per barrel to a 13-year low $30.32 in February, 2016 per barrel with recovery to just $49.78 in October, 2016. The world is oversupplied, and major oil-producing countries have barely reduced production. This has had a profound economic impact and carries with it implications for property market fundamentals and commercial real estate pricing.

Exhibit 4: Cushing OK WTI Spot Price FOB Dollars per Barrel

Exhibit 4: Cushing OK WTI Spot Price FOB Dollars per Barrel (Source: U.S. Energy Information Administration)

The impacts of this environment vary considerably by region and sector. Negative effects are largely concentrated in a few metropolitan areas with high economic exposure to the energy industries (including Houston, Texas and the oil shale region in North Dakota). For most metro areas and property types, lower oil prices have been a net positive. Spending less on gasoline encourages consumers to spend more on other items, which help retail and hotel market fundamentals. Lower oil and energy costs will also reduce certain construction, manufacturing, and logistics costs.

This aids business investment and expansion, which, in turn, increases demand for industrial and manufacturing space. Property markets will see a short-term lift due to a combination of improving tenant fundamentals and lower operating costs.

However, for major energy-producing metro areas, the short-term benefits of low prices will be discounted by the negative impacts on energy-related firms. The long-term health of the property markets in these metro areas will greatly depend on the speed in which oil prices rebound to sustainable levels for U.S. producers. The national economy overall is better off in the near term. The United States is still a net importer of oil at about $190 billion per year, and the decline in prices positively influences the nation’s trade balance. Lower prices directly translate into an increase in household disposable income. Americans have seen a $50 billion to $75 billion ($400 to $650 per household) in gasoline savings this year alone.

Trump has promised significant environmental deregulation for domestic oil, share gas and coal domestic producers. He has also pledged to free the long-standing legal barriers to exporting all three to global economies, making the U.S. a net energy exporter. While this may be good in the short-term for the producers and processors of the energy industry, it might further depress prices on the global market creating another glut which could force lower production levels for the U.S. in the mid-term. However, predicted higher global growth in 2017 and after could absorb this additional supply and avert a price collapse.

5. Slowing New Supply for Commercial Real Estate

Additions to supply will remain limited across the board, with only modest supply growth in a few sectors—multifamily (slowing as we move into 2017), senior housing (creeping up), and single-tenant industrial (regional/nodal distribution centers)—and repurposing in others (suburban malls). Lending sources were extremely skeptical about funding new construction coming out of the last recession, and the current lending environment is showing signs of reticence as bank reserve requirements from Basel III and CMBS risk retention requirements from Dodd-Frank have come into effect in late 2016. It seems likely that Trump will attempt to roll back, simplify and reduce regulations across several sectors including the financial sector and energy.

However, the current relatively low level of supply is not so much due to over-regulation but simple market forces and stringent lender discipline. Even if Dodd-Frank were to be rescinded, the banking system would take years to return to its old levels of funding commercial real estate and its looser underwriting standards. Since many local and regional banks exited real estate lending altogether and seem to be no worse for it, I don’t see an immediate push by this group to get back into commercial lending since prices have inflated and interest rates have gone up. Market volatility has sharply reduced CMBS offerings as well. Insurance companies are stepping in to fill some of the gaps, and private debt funds are emerging as an alternative space.

Exhibit 5: Third Quarter 2016 Completions: Office, Retail & Apartment Sectors

Exhibit 5: Third Quarter 2016 Completions: Office, Retail & Apartment Sectors (Apartment and office figures are based on 82 metros; retail on 80 metros. Source: REIS, “Construction First Glance Report”, 3Q 2016.)

Of all the property sectors, only multifamily can be said to be near long-term new supply, although office is seeing some marginal supply additions in a only a handful of markets for the first time in years. Medical office supply remains at a fraction of its long-term levels due to the long-term uncertainly around the implementation of the ACA and now there is continued uncertainly around the potential dismantling the ACA by Trump.

Tenants, particularly medical tenants, are traditionally extremely risk-averse, and the perceived risk of further regulatory changes will keep most hospitals and doctors on the sidelines of development, reluctant to sign up for brand new buildings all the while continuing to expand in existing buildings.