Midyear Review: 5 Lessons for Commercial Real Estate in 2019

Halfway through the year, we revisit the trends, challenges and opportunities facing commercial real estate owners and investors—and how things have changed since the beginning of 2019.

At the beginning of 2019, we anticipated a slowdown in growth across all commercial real estate (CRE) asset classes for the rest of the year. But six months in, we’ve been met with pleasant surprises. Due in part to an unexpected decrease in mortgage rates and a persistently strong US economy, the CRE market has enjoyed continued growth in the first half of 2019.
These positive trends are likely to continue through the rest of 2019, although CRE owners should remain prudent and prepare for an eventual correction in the US markets. Here are several important lessons for CRE investors at the midpoint of 2019.

1.Mortgage Rates and Economy Are Providing an Unexpected Boost
As the year began, the Federal Reserve was expected to continue regular interest rate hikes. In March, however, Fed Chairman Jerome Powell indicated the central bank was taking a wait-and-see approach on further rate increases this year. This boosted demand for Treasurys and drove down mortgage rates, an unexpected but welcome surprise for the CRE industry.

Meanwhile, the US economy continues to perform well. Unemployment fell to 3.6 percent in May—the lowest rate in nearly 50 years—and wages are expanding. Although the economy will eventually see a correction, it seems unlikely to happen this year.

2.Optimism Continues Across Most Asset Classes
The four CRE asset classes (office, industrial, multifamily and retail) are in a healthy environment. Growing wages are beneficial for rents in the multifamily asset class, particularly in the largest metro areas, where rent constitutes an outsized portion of renters’ income. One area to watch is rent concessions on Class A apartments. During the previous six to nine months, investors have seen some concessions—but given higher rents for high-end units, these concessions aren’t currently having a large impact.

As we noted at the beginning of the year, the office class has finally recovered from the 2008 recession; it has continued to enjoy growth halfway through 2019. The industrial class is performing well in every market, driven by e-commerce business demand for space in proximity to major metro areas. As Amazon, Walmart and other companies increase online sales, they require more industrial space to house the logistics of distributing online purchases.

The trends in online shopping continue to pressure the retail class, although there is nuance. As consumers shift away from shopping at mall anchors, the Class B and Class C malls are challenged to attract retailers and shoppers alike. However, some retailers are using innovative tactics that blend online, mobile and brick-and-mortar strategies, which are fueling positive trends for A-class retail properties.

3.Millennials Still Lead the Push Toward Urban Living
The millennial generation and those behind it continue to show a strong preference for living in vibrant metro areas. In most markets, millennial renters typically value proximity to work and social activities over building space or amenities. The greatest increase in value in the multifamily asset class is found in major cities, owing largely to these millennial renters.

In the highest-paying job markets, one challenge is that there isn’t enough affordable housing to accommodate demand. Additionally, there’s limited need for the high-end multifamily buildings that are being built today—instead, younger renters in every market are moving into potentially less developed urban areas to find more affordable housing.

Notably, while the millennial cohort’s renting preferences are largely consistent across the country, some older millennials in markets such as Pittsburgh and Cincinnati are following the more traditional renter-to-buyer cycle and are purchasing homes in suburban areas.

4.New Construction Provides Challenges and Opportunities
Incentives in the 2017 Tax Cuts and Jobs Act may help address the growing demand for affordable housing. The Opportunity Zones program provides tax incentives for investing in low-income communities. For investors, the program is an opportunity to save on capital gains while developing units in areas where it might otherwise be difficult to build. And it’s not just housing. New retail properties, such as grocery stores, simultaneously cater to the local community and catalyze further investment and economic activity.

While these and other CRE investments offer big opportunities, one dominant challenge is the shortage of skilled labor. As baby boomers exit the workforce, younger generations eschew skilled trades and immigration policies restrict new workers from entering the country, there’s an intense need for labor—not only for new construction, but also for things like renovation and maintenance.

5.The Down Cycle Isn’t Here Yet, but It’s Coming
The economic data and trends in the CRE industry overall don’t suggest a looming correction, despite some concerns in late 2018. That said, the current cycle will end at some point, and rates will eventually increase. Knowing that, investors can plan ahead. CRE investors should stress test frequently to ensure they can withstand cash flow pressure if a correction occurs. They should also ensure they aren’t overleveraged in order to be able to weather a modest downturn and prepare for the next cycle.

With our long-term experience in CRE, we constantly plan and prepare for an unforeseen downturn—even a potentially severe one—so that we’re always in a strong position to help our clients take advantage of the cycle. Even as CRE investors seize opportunities growing out of low rates and a strong economy, they should also continue to prepare for future opportunities by managing their debt and expenses and building the liquidity they need for the long term.