As we approach midyear, the market’s recovery from the pandemic marches on. The volumes across LightBox’s platforms in environmental due diligence, valuation and brokers’ deal listings had a robust first quarter. Forecasts by firms like Moody’s, JLL, Cushman Wakefield and others are being revised upward, queuing up the market for a busy second half. At this week’s CREW Leadership Summit, I spoke with commercial real estate professionals in metros like Dallas, Jacksonville, Inland Empire, Boston, Pittsburgh and Chicago, all of whom universally echoed the same positive market reports as investors look to place capital in U.S. commercial real estate. Will it last? Where are the strongest green shoots? What about all the talk of distressed assets? What risks could derail recovery?
For answers, I turned to three leading economists to ask them what they’re seeing, what barometers they’re watching and whether we can expect the party to continue in coming quarters.
Ryan Severino, CFA Chief Economist, JLL
How strongly is the market coming back? Do we finally have enough stability and confidence to break the bid-ask gridlock?
“I really see this as a multi-speed recovery. Industrial is already past peak vacancy for this cycle. Apartment and retail are stabilizing. Office, which always lags the macroeconomy by 12 to 24 months, should stabilize over the next year. Most property types should rebound strongly. Even retail, whose death has been greatly exaggerated many times, is seeing some solid pockets of strength already. Unknowns around the timing of the return to office cloud the picture, but even there, it’s more of a timing issue. Most employees should be back in an office at least part-time by the end of 2021.”
In office, if big tenants like JPMC are expecting to reduce their space needs by 30 to 50% or more, what does that mean for office investors? What about NOI that derives from future rent estimates?
“There are competing factors here. While work-from-home and flexible space are negatives for office demand, de-densification and office-using employment growth are positives. Net, office demand should decline marginally, but that should further widen the rift between differentiated properties and commoditized properties. That was apparent before the crisis, but the rift will turn into a chasm post-pandemic. Owners of those properties will face difficult decisions about strategy.”
What impact do you see a sunset of the 1031 exchange having on deal-making? Slight or significant impact?
“It depends. The cap of $500,000 tax deferment could potentially not just pull some transactions forward in time, but also create higher turnover as investors sell before reaching the $500,000 threshold.”
Last, where are you seeing the strongest activity building?
“My favorite green shoot is what I will call momentum in the office market. Tours and showings are increasing, sublease space is being pulled off the market, and the best blocks of space are leasing for high rents. We still have some bumps in the road ahead of us, but like many things in CRE, the death of the office has been greatly exaggerated.”
Over the longer term, where are we in the CRE cycle and what do you view as the greatest risks we face?
“We are in the very early stages of the next expansion. As painful as this recession was, it will serve as a reset of sorts in the market. The previous expansion had set a record and we were much closer to its end than its beginning. We now have a chance to start anew. Even if this cycle does not last as long as the previous one, we likely have several years of recovery and expansion ahead of us which bodes well for CRE. At this early stage of the cycle, the pronounced labor shortage could restrain the expansion at the margin. The underlying momentum is too strong in the short to medium term, but lack of workers for open jobs is a structural problem without an easy solution.”
Jim Costello, Senior Vice President, Real Capital Analytics
What’s your forecast on distressed CRE deals this year?
“I don’t think the same sort of distressed opportunities seen in the Great Financial Crisis will be seen this time. We will still see more hotel distress, and there will be some distressed retail debt, but it’s not like a loan during the GFC where the capital stack was messy and simply needed to be cleaned. These distressed loans will be for non-cash-flowing assets. Sure, you might buy an old community center for 10 cents on the dollar, but then what? Where’s your income? Volume is going to increase relative to last year up until December at least, but part of that is just that last year was so bad.”
What’s your take on the sunset of 1031 exchange?
“I think that some of the December 2020 deal volume we saw was due to the 1031 sunset, and I would expect to see more after. Weirdly, I think it will increase prices and decrease deal volume as it will limit the supply of assets to buy.”
How concerned should we be about inflation and its potential impact on the market’s recovery?
“I am not concerned about inflation as a long-term concern. It will be a short-term supply chain issue. I do believe that we will have less growth from capital gains than in the past. The 10-year U.S. Treasury has been on the decline since the early 1980s and there’s not much lower that it can go. Without that wind at the back of the market, people cannot assume that asset prices will climb much faster than income moving forward. In my opinion, it puts a real premium on investment in property tech firms so that people can manage their income and yield better.”
Victor Calanog, Head of CRE economics, Moody’s Analytics
How would you characterize market sentiment as we approach midyear?
“The outlook is shifting toward a more optimistic view, and we’re seeing strong GDP numbers afoot that show the light at the end of the long pandemic tunnel. Significant economic momentum is building. Our 2021 and 2022 GDP forecasts have been restated upwards and are now in excess of 6% for 2021 and over 5% in 2022. This is significant as it puts us at levels of economic activity unseen in half a century.”
What does this mean for CRE performance metrics and forecasts? Is it all rosy?
“New concerns are emerging – like the specter of inflation and overheating. The main issue is whether this would constrain the Fed from maintaining an accommodative monetary policy in the near term. I’m also seeing mixed performance metrics across property types in the 1Q21. Overall, however, there’s less severity for negative rent growth forecasts, and cap rate increases all line up consistently with the story of a greater number of green shoots appearing for 2021.”
Where are you seeing the strongest momentum?
“There are promising pockets in many areas of the U.S. economy. In multifamily, it’s quite likely that the worst is over. The stronger economic outlook, combined with a significant reduction in forecasted new supply for 2021 (maybe due to rising costs) augurs for a turnaround this year. Industrial manifested the strength we expected to see in 1Q21 rent forecasts, and is expected to be the strongest, particularly warehouse/distribution properties, relative to other core property types. The health crisis accelerated structural trends that were boosting industrial prior to COVID, and as a result, this property type is expected to post the strongest rent forecasts in CRE.
“Hotel is undergoing a two-pronged recovery led by robust growth in personal travel or ‘revenge travel.’ Hotel occupancies ended 1Q21 at 50.8%, a significant increase relative to the end of 2020 when they were 34.6%. Those properties serving business travels face a more uncertain future as some conference hosts may offer a mix of in-person and virtual events post-pandemic.”
On the flip side, what sectors are still struggling?
“Uncertainty in office and retail continues to constrain performance. In office, despite strengthening GDP projections, there is still a lot of uncertainty regarding the future of office space post-COVID. I expect to see rent declines and a continued slide in occupancy for the next couple of years. I’m not, however, forecasting the death of office space. I believe the asset’s use will evolve appropriately to accommodate the evolution toward hybrid work flexibility.
“Retail continues to exhibit stress with some subtypes performing worse than others. The health crisis exposed which assets were weak and those that were stronger and widened that wedge. Regional malls are struggling with vacancies in 1Q21 at 11.4%, the highest quarterly increase on record. As retail goes through a major evolution, healthy consumer spending will likely produce winners that can take advantage of market disruptions. Retail vacancies are expected to break historic highs and remain elevated through 2022 before declining somewhat.”
What about CRE transactions and distress?
“After bottoming out in the 2nd quarter of 2020, CRE transaction volume has been steadily bouncing back overall even though underwriting is pretty strict given the market uncertainty. It remains to be seen whether 2021 volumes will match pre-COVID 2019 levels. In terms of price declines, it is looking less and less likely that there will be a systematic decline in CRE prices given where we are in the economic cycle. I expect price declines to be much less severe (with the exception of office and retail) than expected, and hotel may be past the worst of the declines. The reason for this is that CRE market participants, in general, were well-behaved prior to the onset of COVID, and that translates into less pressure to sell at bargain basement pricing post-pandemic.”