Real Estate Investing in The Current Cycle

As we enter the later stages of the current economic cycle, a major topic of discussion among real estate players is how much longer will this trend of slow and steady growth continue. At the Mortgage Bankers Association’s CREF Market Intelligence Symposium 2018 in New York City, hosted by the New York University, Schack Institute of Real Estate, leading industry participants came together to discuss the state of the real estate market and where it’s likely to go, as well as the key factors impacting commercial real estate and the U.S. economy.

Economic Growth Continues

MBA’s Michael Fratantoni, Chief Economist, SVP of Research & Technology, and Jamie Woodwell, VP of Commercial/Multifamily Research, kicked off the symposium with an economic overview, noting that growth picked up in the second quarter and will likely continue through the rest of the year and 2019.

Current fundamentals are steady, with continual job creation, a low unemployment rate of 4.0% and inflation measures ticking up. The Federal Reserve has responded with two rate hikes so far this year, with the potential for two more before the end of 2018. Fratantoni noted that three more rate hikes are possible in 2019, but the Federal Reserve’s actions will depend how the economy performs next year.

There are some causes for concern over the next few years, however, with the latest tax bill adding over $1 trillion to the U.S. deficit over the next 10 years and the unknown impact of trade tariffs on the U.S. economy. These issues, combined with a flattening yield curve, are creating worries about growth potential starting in 2020.

While the Federal Reserve has acknowledged these risks, it has not seen a need to change its strategy as the economic continues its slow and steady growth.

On the positive side, strong demographics are supporting demand for both single-family and multifamily real estate. Fratantoni noted that after several years post-recession of Millennials delaying household formation, they are now moving into apartments and buying homes. Millennials are reaching their peak housing demand years, with many reaching the peak first-time buyer age of 31-32, which suggests a growing need for single-family and multifamily assets.

Investing Through the Current Cycle

Following the economic overview, Woodwell discussed how investors’ expectations have changed as we enter the late stages of the cycle. He noted that recent PREA surveys show that while investors are expecting good, solid income returns continuing, they are less optimistic about achieving the double-digit appreciation returns that they’ve experienced over the last several years due to slowing cap rate compression and NOI growth.

Woodwell did note, however, that steady income growth can continue to make a property a good, solid investment, even without property value increases.

These changing investor expectations are evident in recent Real Capital Analytics sales transactions data, which showed sales volume dropping off last year, suggesting that owners with cash-flowing properties are holding off on selling while buyers are being more cautious if they aren’t going to get the expected returns. However, falling transaction volume isn’t necessarily a cause for concern. The market has experienced record-high volumes over the last few years and is now returning to normal levels, with buyers and sellers being more stringent in their underwriting.

Performance by Property Type

After setting the stage for the state of the U.S. economy and real estate market, panelists at the symposium discussed the impacts on each of the major asset classes.

In the multifamily space, an unprecedented amount of supply is putting pressure on new development and deal returns, encouraging owners and developers to figure out what they need to incorporate in their assets to achieve higher rents. Many multifamily players are finding that offering high-quality amenities and a sense of community make for profitable investments, but location is still a major driver for renters. In addition, while Millennials are still a target renter for multifamily investors, Baby Boomers are a growing rental segment to watch.

For industrial, demand far outweighs supply, especially in core markets. Industrial players’ biggest challenge is dealing with e-commerce’s disruption of the sector. Owners and developers are shifting their last-mile distribution strategies to be closer to their customers, in order to compete with the likes of Amazon that can offer same-day and next-day delivery. As a result, industrial assets are moving into urban areas, with investors determining where to build and buy properties based on if the area’s demographics match their target consumers.

In the office realm, continuing job growth is supporting the sector, but there is some concern regarding lower working-age population growth. In addition, firms are challenged with finding skilled workers to fill positions, which could impact office demand. To address this issue, many owners are moving closer to the talent, identifying urban areas with a high concentration of well-educated and higher-income Millennials as good investments.

Retail remains one of the most challenged sectors, facing disruptors like the rise of e-commerce, changing consumer preferences, and an oversupply of retail in the U.S. Internet-proof segments like dollar stores and off-price retailers are thriving, while electronics and books stores are challenged as they face competition from e-commerce. However, the sector isn’t as doomed as headlines may suggest. Many retailers still see the value in physical stores, with several online retailers opening physical locations, while traditional retailers are changing their merchandise mix and incorporating experiential elements to bring in customers.