MARKET FORECAST: “BE NOT AFRAID”

The year 2014 began with overly aggressive forecasts for property investment, and barometers looking better than at any other time in the recovery. Q1 didn’t exactly pan out as expected as the U.S. economy slowed to one of the weakest paces of the five-year recovery. The general consensus is that Mother Nature is largely to blame for a sluggish Q1, not any long-term, fundamental problem with the market. You could almost hear an audible sigh of relief from attendees at EDR’s Annual Client Summit in Arizona when Ryan Severino, Senior Economist and Associate Director of Research at Reis, assured them during the State of the Market track to “be not afraid” about the rest of 2014. Here’s why.

What Attendees Had to Say…

Just a few days before the annual summit, EDR Insight sent a survey to all attendees, asking them this: Characterize the state of the market in 10 words or less.

The accompanying image shows a sampling of the types of responses that came in from environmental professionals at leading firms across the U.S., from the conservative on the top left to the bullish on the bottom right. The results were a mixed bag, running the gamut from “nothing to write home about” to “fast and furious” and “busy as all get out.”

10wordsorless

“Be Not Afraid”

When Severino took the stage at the EDR summit, he painted a picture of a market that, while slow in Q1, is still on a strong path to recovery heading into the second half of 2014. In his presentation, titled Commercial Real Estate: Market Realities and Economic Change, Severino noted that many of the economic fundamentals underpinning U.S. property markets, and therefore driving Phase I ESA activity, are strengthening as we leave behind Q1 and its harsh winter.

Severino

Highlights from his presentation include:

– Believe it or not, the labor market is starting to accelerate and we are only a month or two away from gaining back all of the jobs that were lost. Despite the slow Q1, job gains are ahead of last year’s pace, and a total of 200,000-220,000 jobs are expected to be created per month throughout the rest of the year. If we achieve that, it could be the pace of growth that could “finally move the needle of demand for commercial real estate.”
– On the GDP front, the results for Q1 were not good to say the least (0.1% growth), but this was due to “severe winter weather that really did restrain economic activity.” The slow start to the year is not to say that “Armageddon is upon us, but rather a bump in the road due to a very short-term factor.” As a result, a lot of the economic activity that “would have occurred in the first quarter simply got diverted to later quarters. We still think we can get close to 3% GDP growth in 2014, which would easily be the best result we’ve seen since the downturn.”
Apartment continues to be the darling of commercial real estate, but the good news is that investors are increasingly looking for opportunities outside primary markets and the multifamily asset class. Keep your eyes open for pockets of opportunity in metros like San Jose, San Fran and Seattle. These are all active technology markets, while Houston is an energy-centric market. Not surprisingly, all of these metros outperformed the overall Phase I ESA market in Q1 based on EDR Insight’s ScoreKeeper results.
– In the CMBS sector, things are improving but challenging. Here’s why: In 2006-2007, we saw annual issuance of about $230B spread across 38 players. After the slow Q1, today’s forecast is for annual volume this year of about $80-100B. At last count, there were 37 organizations out there trying to issue CMBS so that means we have about the same sized universe of originators as we had during “bubblicious boom years” but only one-half to one-third of the volume.
– The good news overall is that the main headwinds (e.g., weak housing, unhealthy bank balance sheets, etc.) that have really been holding the economy back for the past 4-5 years have largely dissipated at this point. If you take GDP, the accelerating labor market and healthier bond market…all of these positive factors together in the absence of the headwinds from the past few years, and we could finally see the transition year when the economy shakes off the shackles of everything that’s been holding it back and starts to move to an environment more conducive to growth in commercial real estate.
– Weaknesses and threats remain, but “there are fewer specters of disaster that might lead us to temper our views.”
– The general economic outlook for 2014 is “the most positive and most sanguine outlook Reis has presented since the downturn began. I’m not read to call it The Breakout Year, but it could definitely shape up to be a “Transition Year.”

Other Reasons for Optimism

In other recent news, consider these developments from both outside sources, as well as some anecdotal intel from summit attendees:

•    Real Capital Analytics, a trusted source of data on sales of significant commercial property, reported that April sales were up 23% year-on-year. Year-to-date through April, total volume was up 20% above the same period last year.
•    Several large portfolios drove gains in Phase I ESA activity in April and May, likely due to pent-up projects in the pipeline that were delayed in Q1.
•    Property prices increased 2.4% in Q1, according to the latest Moody’s/RCA CPPI, and are up 15% over last year. This bodes well for investors looking at commercial real estate as an investment option.
•    Volume and price trends across most property types reflect growing activity by smaller scale private investors, indicative of new players coming onto the scene especially in secondary markets.
•    Most commercial real estate markets are moving from a recovery stage to an expansionary one.
•    Due diligence on new development projects are ramping up, which is typically a sign of better times ahead.
•    Talk of more competitive loan terms are becoming more frequent, another sign that markets have recovered from the crisis.
•    Despite intense competition for loans and the line pushing for taking on more risk, risk managers continue to apply relatively conservative underwriting standards.
•    Hot spots for Phase I ESA activity correlate closely with the “metros to watch” on PricewaterhouseCoopers/ULI’s annual ranking. The top metros, including Houston, Dallas, Austin, San Francisco and San Jose, all outperformed the Phase I ESA market in Q1 with the exception of a few in New England that were adversely affected by a tough winter.
•    In the M&A sector, the first quarter set a positive tone for 2014, and Q2 started with strong growth in April suggesting that this quarter is already poised to overtake Q2 2013’s deal value.

Today’s Forecast

Based on Severino’s insightful presentation in Arizona, the general forecast for property investment and lending is for continued, albeit slow, growth. Property fundamentals are steady and improving slightly, and transaction volume will continue to increase, with sales expanding into the secondary and tertiary markets (provided interest rates do not significantly rise). Although the Mortgage Bankers Association projects that commercial property originations will increase by 7% in 2014 and another 6% in 2015, anecdotal intel from lenders suggest that much of the growth in loan originations today is due to stealing market share from competitors rather than from true organic growth in lending. Collectively considering the myriad drivers of demand for property due diligence (e.g., M&A, lending, SBA lending, investment, telecom, CMBS, etc.), a conservative forecast for 2015 is reasonable, certainly in the single digits notwithstanding any unforeseen macroeconomic upset. This forecast is consistent with the latest expectations for the economy and commercial real estate market. As I said at the summit, “I am optimistic about slow and steady growth based on what I’m seeing and hearing, and certainly nothing is suggesting a decline at this point so that’s good news.”

By most accounts, it seems another downturn isn’t imminent, but then, neither is strong growth. Take to heart Ryan’s words: The 2014 outlook is “the most positive and most sanguine outlook Reis has presented since 2008.”