FINDING YIELD DURING RECORD ECONOMIC RECOVERY

NOTE TO READERS: Below is an article that was just published in the Summer edition of the EBA Journal. The focus is on where the commercial real estate market stands at the first half of the year comes to a close, as well as a snapshot of the year’s fastest-growing markets for Phase I environmental site assessments and how technology is being harnessed by CRE professionals. Details on other articles featured in the summer edition of the EBA Journal are provided in the FOR MORE INFORMATION section following this brief.

 

 

As we approach the midpoint of 2018, the economy just passed an important milestone: This is now the second-longest expansion on record. (And, thanks in part to the stimulus of federal tax reform, there is a very high probability that this will become the longest expansion in history.) As recovery marches onward, debt originations for commercial property investment continue to rise and have now exceeded the prior peak from 2015. Given the late stage of the cycle, lenders are disciplined in their underwriting, particularly for construction loans. One of the biggest challenges in today’s market lies with investors, who are rich with available capital and have a massive appetite for yield, but face the difficult task of finding properties for sale that offer an attractive return on investment. Market pressures are funneling interest toward smaller metros as well as to sites that present value-add opportunities.

Quest for Yield Marches into Smaller Metros
Environmental due diligence is conducted prior to most commercial property deals, so a look at where demand for site investigations is heating up reveals another interesting trend in commercial real estate this year. The pace of commercial real estate transactions correlates closely with environmental due diligence trends so both metrics have
experienced moderating growth over the past few years. In 2018, the number of commercial property environmental assessments grew by a modest three percent in the first four months of this year compared to the corresponding period of 2017. Yet activity in the ten highest-growth primary metros averaged a much more robust 23 percent growth. The data reflects a market environment in which investors are looking beyond metros like Boston, Chicago, LA and New York where buyers are aggressive and properties for sale are scarce. The quest for yield takes available capital into smaller metros where prices are likely to be lower and competition less fierce. Detroit, a city whose story of urban revitalization is well-told, sits at the top of the list of high-growth metros this year, followed by Jacksonville, San Francisco, San Diego and Charlotte. Houston, a metro that withstood a devastating hurricane last year and is recovering from the fall in oil prices a few years back, made the list in ninth position.


In these ten MSAs, and other smaller metros, across the U.S., investors are shaking the trees for opportunities for adaptive reuse or infill investment in popular downtown areas with the potential for a pay off over the long term. At this stage of the recovery, the dynamics of the deal are changing. Property price increases are no longer a given as
some metros hit the peak of their recovery. So investors’ thinking switches to value-add opportunities:

“Where can I get a good deal on a property in a strong market, improve it and sell for a profit down the road?”

In every major asset class today, the ways that space is being used are changing. Nowhere is this more true than in retail as traditional heavyweights like Sears, Toys R Us, JC Penney and others shutter stores. The market is recognizing that needs are evolving so retail does not necessarily have to be repurposed into retail. Yesterday’s mall could be tomorrow’s medical center or senior housing facility or distribution center. In the office sector, owners face competition to lure tenants with cutting-edge technology designed to appeal to today’s young professionals or energy efficient improvements to reduce operating costs. Mixed use developments are in vogue. The user experience matters. Amenities matter. Sustainability matters. As investors seek out ways to improve properties and create value, it creates strong demand for site redevelopment and repurposing.

Better, Stronger, Faster
It hard to think about the state of the commercial real estate market this year without giving attention to technology. The pace of technological change is accelerating in every sector of the economy, and the commercial real estate sector is no exception.

If you look back over the past century, you’ll realize how much shorter the adoption rate of new technologies has become. Consider when once-innovative technologies like the telephone, electricity, or car were first developed. They reached mainstream adoption over 40-50 years.

Contrast that with how quickly we’ve all gotten addicted to new technologies like smart phones or tablets to make us better, stronger, faster. According to Soren Kaplan, keynote speaker at EDR’s PRISM conference in Scottsdale, “mainstream adoption of technologies is closer to five or six years, than five or six decades” (see graph).

The MIT Center for Real Estate is now tracking 2,300 starts ups promising to our market more efficient. At the recent MIT Global Real Estate Forum, Erik Brynjolfsson, director, MIT initiative on the digital economy, observed:

“Commercial real estate is on the cusp of  moving from a potentially inefficient industry to one that is notably more efficient. This sector is ripe for machine learning simply because of the huge and growing volume of data that isn’t yet being tapped.”

Thanks to growing traction of technologies like machine learning, data visualization, analytics and platforms, the entire commercial real estate ecosystem will soon have better tools for decision-making in ways that we can’t even fathom today. Vyom Gupta, COO of LEVERTON, observed at PRISM that “In commercial real estate, we have so much data that we are just not mining. And for much of it, you won’t be able to mine it without a machine. This is changing.” LEVERTON is currently helping real estate services firm Savills Studley harness artificial intelligence to create data visualization and analytics from end users’ imported real estate documents, such as leases to improve ease of use.

Times Are Good, but Keep Your Guard Up
Amid strong market fundamentals, interest in site reuse, rapid technological advancement and intense competition, the commercial real estate is performing well this year. As anyone who’s been in this industry for a few decades will tell you, the cycle will turn, but the highest risk of recession isn’t until 2020 or 2021. So let’s enjoy strong market conditions while they last, but don’t take your eye off the ball. As Ryan Severino, chief economist at JLL, said at EDR’s May PRISM conference,

“It’s difficult to plan for the end of the party when you’re still there drinking and having a good time, but there will be bumps in the road at some point and you want to make sure you’re ready.”

FOR MORE INFORMATION

The EBA Journal’s Summer edition is posted here for association members. In it, you’ll find other articles by EBA member experts:

  • A Look into a Vapor Mitigation Project
  • SBA Environmental Due Diligence Updates
  • Revisions to the ASTM E 1527-13 Standard
  • Integrating Building Energy Performance into PCAs
  • and more.