Part I of II
Thanks to EBA President Bill Sloan at Commerce Bank for inviting me to open up the EBA Winter Conference in sunny Long Beach—leaving our sub-zero New England temps behind. This is Part I in a two-part series based on my five predictions for 2018.
A LOOK BACK AT 2017
As the old marketing slogan went: “We’ve come a long way, baby.” Since the post-recession 2007-2009 period, the economy progressed from GDP contraction of more than eight percent to three percent growth–the third-longest recovery since World War II (102 months and counting). Banks have moved from the days of hundreds of bank failures to the days of record-high profits. The recession and the CMBS shut down are now far back in the rear-view mirror.
In hindsight, I think most would agree that 2017 shaped up better than many of us expected it to at this time last year. Last January, the market was gearing up for the transition to a new Presidential administration. 2017 left us with still-strong property fundamentals, continued moderation in the growth of commercial property transactions and concerns that this long-running bull market has run its course. So where is 2018 likely to take us?
The big question on everyone’s mind is: When’s the next downturn?
Well, as long ago as 2015, economists were saying the recovery had run its course, and recession was near. They were wrong.
Some like to say commercial real estate has an eight-year cycle, but the thing is that recoveries don’t have a shelf life. At least not this one. For that, we can thank the slow pace of growth that has kept the market bumping along the top of the recovery for the past few years. What really matters are these barometers:
- Inflation is still low.
- Job growth continues.
- Business confidence is strong, partly due to tax reform.
- The global economy is doing really, really well so the U.S. is part of a broader expansion.
- The housing market is finally breaking out of its slumber.
It is these strong macroeconomic fundamentals support my first prediction:
In April, the current expansion will become the second-longest on record—one that will remain broadly conductive to healthy commercial real estate fundamentals. (By the way, most aren’t expecting recessionary conditions until the latter half of 2019, after this year’s three interest rate increases.)
In terms of the dollar volume of commercial real estate transactions, 2017 ran hotter than 2013 and 2014, but fell short of 2015 and 2016. Should you be nervous? No, because property fundamentals are still positive, and there are pockets of record-high sales in some asset types, like suburban office and industrial.
The reason for the slowdown in transactions is the gap between buyers and sellers in two areas:
- The supply of properties, especially good ones, for sale is low, while the $152 billion in capital looking for a home in U.S. real estate is staggeringly high.
- The price buyers are willing to pay at this late stage of the recovery is low (“Who wants to overpay especially if the next downturn is around the corner?”), while the price sellers expect to get is high (“It’s a great property, so pay me 2016 pricing for it!”).
Many investment funds are below their intended investment levels, so to find a home for their capital, they’ve started migrating to smaller metros to shop around for deals. Here, many of them will look for opportunities to buy at a discount, make some value-add investments or repurpose outdated properties in order to get a solid ROI.
In terms of asset class, the future of retail and industrial are worth mentioning here.
The story in retail is a classic glass half-empty, glass half-full scenario (see slide). 2017 was marked by dozens of major chain bankruptcies, creating headaches for shopping center owners and lenders—and more are on the way this year. With the rise of e-commerce, as much as 40 percent of retail centers could be obsolete in two years. Yet retail openings are at record highs and growing. There is significant demand for assessing retail sites for investment and priming them for reuse. Retail has evolved before, and it is evolving again. So let’s start talking more about the opportunities to transition outdated retail space into the uses the market is demanding, and less about the demise of retail.
In industrial, opportunities are evolving on Internet time as e-commerce explodes, and major players scramble to build a new universe of distribution centers and warehouses to complete the last mile of delivery. This trend led to the double-digit growth that construction and investment in industrial sites experienced last year, and the good news is: It’s just the beginning! If you’re a lender looking for a new business opportunity, one of the most promising areas is in financing smaller distribution facilities with online retailers. And good news for environmental professionals is that many of these deals involve industrial sites in or just outside of metro areas, some of which are challenging infill sites with contamination that needs to be addressed.
Just as investors are on the hunt for good deals in the years that remain before the next recession, so too are lenders looking to grow originations prudently as they deal with uber-competitive conditions. The Mortgage Bankers Association cites lending growth of five percent in 2017, due partly to the handsome rebound in the CMBS sector after a slow start to the year.
The MBA expects originations to remain at 2017 levels this year–the first year in a long time that loan volume isn’t expected to be on a growth path. Part of this slow-down is attributable to the wall of maturities that was a concern the past three years clearing without too much trouble. (There is still a fair amount of CMBS refi business coming up in the next 12 months, but volumes could taper after that.) The lenders with whom I spoke at EBA reinforced the next point I made: Competition is steep among the myriad sources of capital looking to finance property deals. It’s not uncommon for as many as 15 to 20 lending sources (banks, life companies, private equity funds and REITs) to be bidding on the same loan. Lenders are also looking to stack loan portfolios with low-risk deals as the market heads into the later stages of this cycle.
One factor that bodes extremely well for the market is the disciplined approach lenders have exhibited in their underwriting in recent years. In today’s “risk-off” environment, the numbers matter more in underwriting–numbers like a property’s rental potential, vacancy rate and any adverse environmental conditions that could impact its value. As I learned at last fall’s Risk Management Conference in Boston, lenders also have their eye on the horizon for signs of red flags. Some lenders are preparing for weakening credit risk scenarios—looking at which borrowers may be at risk two or three years out. Some aren’t doing seven-year loans anymore. As one speaker said, “You prepare for war during peaceful times.”
So continued economic growth, more property deals in smaller metros, a focus on property improvements and a risk-adverse lending climate are this year’s first three market predictions. Part II of this two-part series continues with my final two predictions for the New Year.