A Recession May Be Coming, but Not for Commercial Real Estate Investors
Financial headlines have been full of worries about a possible recession and a downturn in commercial real estate markets. Recessions often precipitate a decline in real estate markets, but long periods of increasing construction and rising property prices may pose risks of their own. Stock prices fell sharply in December in a bout of turmoil that both reflected these concerns and fed the fears.
Lately, though, we’ve seen increased evidence that this was a false alarm. Sure, there has been troubling economic news from abroad, interest rates have moved higher, and the economic expansion is one of the oldest on record. But the challenges today are typical of the types of risks that the economy faces regularly, without heading into a recession. Indeed, as former Fed Chairman Ben Bernanke said recently, ”I don’t think economic expansions just die of old age... they get murdered.”
What are the typical weapons found at the scene of such a macroeconomic crime? A detailed reading of the historical record indicates three types of excess that have preceded every recession and commercial real estate downturn: overbuilding, overheating, and over-indebtedness.
Overbuilding is all-too-familiar in commercial real estate. Yet current trends in construction are actually lagging the rest of the economy. In the fourth quarter, commercial construction put-in-place was 1.3% of GDP, below its long-run average of 1.5%, and has been below average since 2008. Moreover, there’s plenty of demand to match the new supply, keeping vacancy rates low.
Signs of overbuilding in the macro economy include not only construction (both commercial and residential), but also business investment in equipment and household purchases of consumer durables. Today, their share of GDP is 25.2%, which is still below the pre-recession average of 28.1% (I’m looking at the seven recessions since 1960). Neither the macro economy nor the commercial real estate sector appears overbuilt.
Overheating manifests itself as rising inflation (for the macro economy) and speculative prices (for real estate). There were concerns last year that inflation was picking up, especially with the unemployment rate falling to the lowest level since the late 1990s. The uptrend proved short-lived, however, and was largely due to a couple of special factors (telecommunications, auto insurance) causing a temporary rise in core inflation (the Personal Consumption Expenditure, excluding food and energy). These soon ran their course, and core inflation has slowed since June 2018 to a 1.7% annual rate.
Commercial property prices do warrant a close look for signs of overheating; indeed, the CoStar Commercial Repeat Sales Index is 30% above where it stood in December, 2007. Capitalization rates, which decline as property prices rise, have moved down to low levels last seen in the period preceding the financial crisis.
These increases in property prices, however, reflect solid fundamentals. Across all the major commercial property sectors, vacancy rates are low (remember that rising supply has been roughly matched by rising demand), and net operating income has kept pace with property prices. And in a market where bond yields are as low as they still are today, cap rates are comfortably above Treasury yields, and thus offer an attractive spread for investing in commercial real estate.
Over-indebtedness may leave households or businesses unable to handle economic shocks. When this happens, it results in spending cuts—not to mention bankruptcies or foreclosures—that can quickly spread financial distress throughout the economy.
But borrowers have been cautious since the financial crisis, and lenders have generally maintained prudent underwriting criteria. Households have deleveraged, with debt burdens the lowest they have been since at least 1980, according to the Federal Reserve. Corporations have issued lots of bonds, but also enjoy record corporate profits.
Commercial real estate has deleveraged as well. Total commercial mortgage debt has risen at a 2.4% rate since 2010, well below the 7.6% average rise in property valuations. Among real estate investment trusts (REITs), a reliance on raising equity capital to fund their property portfolios has resulted in the lowest leverage ratios in at least 20 years.
REITs have benefited from this favorable economic backdrop. Earnings have continued to rise, and share prices rebounded thus far in 2019, delivering a total return of 11.4% in January and an additional 0.5% in February.
There still could be bumps in the road, of course. Key risks to keep an eye on include possible impacts of trade wars and Fed policy, especially if inflation should rise again. And while commercial property prices today do not look overheated, an acceleration in price growth above and beyond net operating income could signal trouble ahead. For now, however, 2019 appears set for a favorable performance for the economy, and for commercial real estate.
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