CBRE Flash Call | Opportunities in a Volatile and Late-Cycle Market

Flash Call Recording

Opportunities in a Volatile and Late-Cycle Market
February 14, 2019

Flash Call Summary

2019 CRE Outlook: Opportunities in a Volatile and Late-Cycle Market

Executive Summary

• Continued strong fundamentals combined with historically deep and liquid debt and equity capital markets provide good momentum for 2019.
• The Fed has paused its hike in rates due to a weak Q4 2018 and global uncertainty but will likely resume rate hikes later this year.
• Wild cards are whether the U.S.-China trade dispute and Brexit are successfully resolved. We expect both will be.
• Pricing is at or near the previous peak for most asset types in prime locations, so investors are looking for yield in secondary markets and alternative asset types.

Global Outlook

There were three main reasons for equity market volatility and a reduction in global confidence late last year:

1. Fed Action: Guidance by the Fed that it would continue rate increases in 2019, despite moderating U.S. inflation and slowing overall growth.
2. China: A big slowdown in Chinese imports suggested the possibility of recession in that country.
3. Slowing Global Growth: Negative GDP growth in Germany, Italy and Japan suggested that other developed economies might be dragged down by China.

Some of these issues—notably the Fed’s posture and Japan GDP growth—have been resolved and we expect government stimulus to revive China’s growth. We remain wary of the impact of Brexit on the U.K. economy and British pound. While global markets may experience a choppy first half of the year, there should be noticeable improvement in the second half, as we expect a U.S.-China trade deal and the U.K. and EU to come to a resolution on Brexit.

Read more in CBRE's 2019 Global Real Estate Market Outlook.

United States Outlook

The Fed has changed course and taken on a much more dovish tone this year. There currently is no evidence of the potential for rising inflation, even though we are seeing it in commercial real estate construction costs—mainly from tariffs. Nevertheless, we think the Fed will turn more hawkish as the year progresses and the global economy regains steam. Expect to see two more interest rate rises despite the current dovish signals.

Our view is that while the U.S. economy may slow slightly in 2019 due to the waning impact of tax cuts, there will not be a recession. Consumers remain confident and retail sales are good. All in all, the U.S. economy will still have an above-trend performance near 2.4% GDP growth. The growth in late 2018 and early 2019 may be a blessing for real estate as it pushed down the Treasury rate and deflated a growing equity market bubble.

Read more in CBRE's 2019 U.S. Real Estate Market Outlook.

Economic & Real Estate Cycles

The economic cycle has been lengthening over the past 30 years. The current cycle is proving very durable due to the lack of inflation and its end does not seem imminent. We have not seen a speculative bubble and fear of the end of the cycle seems to have constrained risky over-investment.

While there has been a buildup in supply in the main markets, supply and demand generally remain in balance. This is the most disciplined cycle of the past 40 years. Developers and lenders have been cautious, in part due to memory of the last crisis.

U.S. Commercial Real Estate Outlook

Total investment volume in 2018, including entity-level transactions, was $534.8 billion—a sizable increase of 14.8% from 2017. Excluding entity-level deals, 2018 investment volume was still 4.9% higher than 2017. Cap rates were largely unchanged, except for slight decreases in industrial and multifamily assets.  View CBRE's U.S. Cap Rate Survey H2 2018 - Advance Review for more information.

Looking ahead this year, the number of deals brought to market in January alone materially exceeded that of last January in all asset classes, led by Industrial almost doubling to $2 billion. While there was a slight uptick in cap rates in January, more investors are looking to make their returns based on income in 2019 vs. capital appreciation.

Looking ahead this year, the number of deals brought to market in January alone materially exceeded that of last January in all asset classes, led by Industrial almost doubling to $2 billion. While there was a slight uptick in cap rates in January, more investors are looking to make their returns based on income in 2019 vs. capital appreciation.

Investors will be looking at secondary markets more closely than ever this year in the search for yield. As for cross-border capital flows, the strong U.S. dollar remains a risk since it increases the hedging costs of foreign investors coming into the U.S., particularly from the EU.

CRE Sector Outlook

Office

• Expect increased capital expenditures and tenant-improvement allowances, as lower tenant renewal rates will cause some concern for CBD office assets and a widening premium for new or modernized assets.
• Underwriting will remain steady with rent growth assumptions based on normal inflation of 3% annually.

Industrial

• Expect a continued landlord’s market with strong rent growth.
• Industrial rent growth usually pegged around 5/4/3+.
• Pricing will return to prior peak levels.

Retail

• Despite the persistent negative headlines, there has been a pick-up in broker-opinion-of-value activity and deals in market.
• Regarding pricing, buyers are beginning to meet seller expectations for small to mid-sized shopping centers. Non-core shopping centers and those in secondary markets will still see thin bidding pools.
• Landlords and lenders are reevaluating the traditional metrics by which store performance is measured.

Multifamily

• While there is some oversupply/rent softness for new Class A, renters of older apartments can expect another year of rent growth above the historical average (likely 3% or more).
• Buyer 10-year hold periods have become standard on multifamily deals (up from seven years) due to debt/yield curve considerations (i.e., no more short-term debt arbitrage).
• The National Multi Housing Council predicts that while capital appreciation will be challenging in the near term, solid rent growth should occur.

Hotels

• The U.S. lodging industry has been operating at peak levels for the past three years and 2019 will be no different.
• Sales volume should mirror 2018’s level. Overall returns on hotels may be the highest of any CRE sector over the next three years.

Alternatives

• Spreads between the main CRE asset classes and their alternatives continue to narrow as equity investors are prepared to take greater operational risk.
• The rise in rates in 2018 did not have a measurable impact on net-lease yields. The abundance of capital allocated to the sector and resulting demand offset the increases.
• Despite tightening initial yields, interest in alternatives continues to grow.

Debt & Structured Finance

• Multifamily is seeing a large number of market makers in addition to the GSEs.
• Weaker regulations have helped banks to increase lending. Partially as a result, CMBS lender continue to lose market share to banks.
• Life insurance companies, typically very conservative lenders, are expanding their targets to include more mezzanine and construction lending.