DDD Fall Wrap Up: 4Q17 Update on a Market in Transition

EDR just wrapped up our fall Due Diligence at Dawn series in Houston, Dallas and Boston.

The property due diligence market is a market in transition. Transition due to the cyclical nature of the market. Transition due to regulatory forces on lending operations. And transition due to technological advances. Within this transition is disruption—but also opportunity. That’s where my focus was at the fall events. A few highlights from my 4Q17 market update track:

Commercial real estate deal-making is moderating.

2017 activity continued at the slower pace of the previous two years, yet no one seems overly concerned about that yet. The declines can be explained away by some key changes in the fundamentals of the deals: higher interest rates making borrowed capital more expensive, and sellers expecting 2015 or 2016 prices for their properties but locking horns with buyers who want a better deal given that property prices are leveling out after seven years of steady increases. Add to that fewer buying opportunities in hot markets like Boston, DC and other gateways and it adds up to a lot of money chasing fewer deals. In this context, the four consecutive quarters of declining activity through 3Q17 are not all that surprising.

Value-add opportunities are the new name of the game.

Investors are getting more creative and looking to value-add opportunities. If price increases are no longer guaranteed and that $10 million office building or $2 million strip mall may not be worth more a few years down the road, buyers are rethinking their strategies. Where are the properties I can get at a good price, improve on and sell for a profit? This is translating into more deals in smaller metros like Portland, Charlotte and Austin. It also drives site reuse opportunities and energy-efficiency audits and improvements—both strong markets for environmental consulting firms.

“Risk-off” due diligence is here.

If deals are not the slam dunk they may have been a few years ago, the due diligence needs to change. In estimating a property’s value, there is a smaller margin for error. A lender viewpoint I heard at last month’s Risk Management Association conference is Boston was that”

“Lenders are starting to prepare for weakening credit risk scenarios. They’re looking at certain borrowers who may be at risk two or three years out. Some aren’t doing 10- or even 7-year loans anymore.”

And as prices level out, deals become more of a numbers game.  Quantitative measures like rent and resale value matter more. Buyers need to be mindful of any issues, including environmental ones, that could impact whether a property will hold its value over time. Lenders are looking for very predictable income, and they’re shying away from construction markets with flimsy numbers. The market is getting more cycle aware and planning for the short term.

Retail is not a dirty word.

I have seen many doomsday headlines this year about the thousands of store closures, but it’s a classic glass half full-half empty scenario. It is true that retail closures are creating difficulties for some mall owners losing traditional anchors and for lenders with holdings on these properties. The upside is it is also opening the door for outdated properties to be redesigned into more relevant uses. Malls and old shopping centers are driving demand for site assessments and design work as they get repurposed into mixed use, medical centers, senior housing or “power villages” if the demographics are right. Retail isn’t dead. There’s a net increase of 4,000+ openings this year. This asset class is going through yet another transformation and the trend is opening up opportunities to use space in a new way that is consistent with the changing demands of consumers in today’s e-commerce culture.

 Phase I ESA market bumping along top of recovery.

Amidst the market changes, the total volume of Phase I ESAs in the U.S. is running fairly even with last year, which says a lot given the moderating growth in commercial real estate transactions. There is also significant variance from region to region, state to state, and metro to metro. Highest-growth states this year have been Texas, Washington and Oregon driven by high investor interest in metros like Austin, Seattle and Portland. Highlights on our three fall DDD cities:

HOUSTON’s audience has a special place in my heart given the year they’ve had from the low of Hurricane Harvey wreaking havoc on their offices and homes, to their epic World Series win. The resilience I heard in the stories clients shared were really moving. Points in Houston’s favor:

  • Houston is the 12th largest Phase I ESA market in the U.S.
  • Also a major industrial market of interest as buyers look to port cities for distribution centers, warehouses and other development to support e-commerce.
  • Houston is ranked 7th in the U.S. for office using job growth, a major driver of investment.

The audience at the DALLAS DDD wasn’t going to let me leave without talking about the intense pricing pressures on Phase I providers today. True and it’s a challenge that unfortunately is only intensifying. From a market perspective, Dallas has a lot going for it:

  • Ranked 5th on the ULI/PwC Emerging Trends report of hot real estate
  • markets for 2018.
  • Tied with NYC for 2nd in the nation for office-using job growth.
  • Sixth largest market for Phase I ESAs in 2017 according to ScoreKeeper.

Seventh strongest homebuilding market, driven by its status as a magnet for corporate headquarters.

BOSTON is an extremely competitive market for real estate with multiple buyers jumping on desirable properties:

 

  • Notably, Boston is the only Northeast MSA that made it on the Urban Land Institute’s top 10 list of metro hot spots for 2018.
  • Top three pick for Amazon’s next headquarters (along with Dallas and DC), although it is worth noting that not a sing
  • le person in my DDD audience thought Boston would win!
  • Boston is ranked as the 8th hottest industrial market, and benefits from an influx of highly educated millennials.

***

Our market is shifting and as it does, new opportunities are emerging for property due diligence. There is also a long list of uncertainties and risks that could upset this long recovery. A cyclical downturn will come, but no one knows when. The forecasters put it 12-18 months out. Now is the time to plan for the long-term, to turn a strategic eye toward your recession plan. What new markets does your firm want to chase? What’s your strategy for competing in an increasingly competitive market where efficiency is king? Are you positioned to weather a decline in property transactions or an unforeseen market shakeup? Who are the new funds, lenders, market sectors that your firm has in its crosshairs?

Thanks to the clients who joined us at our DDD events this fall!