A look at where today’s economy will take commercial real estate pricing in the future.
In our last post, we addressed what we believe are the three main reasons prices have soared since the end of the Great Recession. Reason #1 is the low cost of capital precipitated by the aggressive easy money policy of our central bankers. Reason #2 has to do with the degree to which property values declined after the last market peak.
Buyers, sensing a bargain, began taking advantage of low interest loans to snap up properties that had lost as much as 50% of their value. Reason #3 is the lack of construction of the next generation of buildings to satisfy the demand of businesses that started to grow again. Southern California is running out of land and what’s left is very expensive. Without new inventory to meet that demand, expanding businesses have driven the price of existing product well beyond the previous market peak.
While it helps to understand how we got to this point, the more important question that needs answering is; what will happen next? Getting a firm grip on the answer to this one is like trying to grab hold of a fish off the hook in the bottom of a boat. Just how the market will move and by how much is dependent on multiple variables and each market has its own peculiarities.
Let’s take a look at where the economy is today with an eye for how those conditions will impact the commercial real estate world. From high altitude, things look to be going pretty well. GDP growth is running close to 3% again, job growth is strong and consistent, wage growth is finally picking up and the equities markets keep setting new record highs. Plus, we are now operating under a new tax code that clearly benefits virtually every American business, including those who compete heavily in the global markets. Trillions of dollars of expatriated cash is coming home to America and businesses large and small are poised to take advantage of lower marginal income tax rates, new expensing rules and a variety of other incentives in the tax reform bill that are meant to stimulate economic growth. Some economists believe the new tax plan will breathe new life into the current economic expansion, which is already the third longest in American history. If it lasts until mid-2019, it will be the longest ever.
That all sounds pretty darn good to us, but there are some ripples in the water that give us pause and make us wonder if other macro-economic factors will combine to dampen the enthusiasm for commercial real estate. And, those ripples will be caused by our very own central bankers, who gave us the cheap money that got the party started in the first place. The actions of the Fed going forward, will impact the cost of capital and the yield on capital, which will, in turn, weigh heavily on business decision making across the board, including how much to pay for commercial real estate.
Chances are good that we will see the Fed make up to four hikes of its benchmark Federal Funds Rate in 2018. The Fed cites an uptick in inflation and wages as a reason to continue its more restrictive monetary stance. Just the anticipation of more frequent rate hikes has driven the yield on the 10 Year US Treasury up to 2.9% in February, nearly double what it was just a year ago. That yield is used as a benchmark for almost all commercial property loans, which means we can say with some certainty that mortgage rates will move substantially higher. Higher rates means more debt service, which reduces cash flow for leveraged investors and increases occupancy costs for owner/users. In other words, buying power will be eroded to some degree, which would put downward pressure on property values and lease rates. We just don’t know by how much.
Factors that we expect to help reduce the likelihood of a price correction include, record low vacancy, the almost complete lack of construction in most Southern California submarkets and the expected near-term boost in business activity resulting from the tax cut.
The vacancy rate could triple and still be under 7% in major submarkets around Southern California. Even if demand for space fell sharply, it may only slow the rate of rent and sales price growth, which has been rising at a double-digit pace for several years. In fact, an increase in available space might give expanding businesses a much needed break from the extraordinarily tight conditions they are currently facing. Both rents and sales prices are already at all-time highs and demand continues to outstrip supply across the region. So, we expect sales prices to keep increasing as long as long term mortgage interest rates don’t rise more than 100 basis points from their current levels. Leasing demand will remain strong enough to move sharply higher again this year, and would get another boost if would-be buyers are forced to back into leasing due to a spike in borrowing costs.
Construction activity is at a virtual standstill, except for select submarkets out in the Inland Empire. Without new inventory, demand will almost certainly remain well below supply. Overbuilding has historically been a key metric when analyzing market corrections, but it will definitely be left out of the equation this time around. The land just isn’t there for over-zealous developers to build on, and what is available is too expensive to pencil a project, even at today record high lease rates and sales prices. Those who have projects in the construction queue will be big winners, but don’t expect to see much more product come out of the ground any time soon. Without new product chasing even higher rates, owners of existing inventory will not suffer the effects of competition from higher quality product, and even those owners of functionally obsolete buildings will continue to achieve rate premiums.
The new tax law is loaded with goodies meant to stimulate new investment by America’s businesses. First year bonus depreciation of up to 100% of the cost of capital expenditures is now allowed. Additionally, new “Qualified Improvement Property” rules also for the immediate expensing of tenant improvements paid for by tenants or their landlords, which should help in lease negotiations going forward. In effect, virtually any asset with a designated useful life of 15 years or less can be fully written off in the year it is purchased. The new rules also apply to the purchase of used equipment.
Building owners, pursuant to an expansion of “Section 179” rules are now able to immediately expense the cost of a new roof, HVAC system, fire/life-safety system or security system rather than depreciating them over the economic life of the structure. That will be a big help to property owners with deferred maintenance issues in those categories.
Add in lower marginal tax rates for C Corporations and pass-through entities, and the new law looks to give businesses and investors another good reason to be optimistic going forward.
So, we believe that while economic headwinds are a real possibility, there is still enough impetus for further gains in lease rates and sales prices in 2018. Buyers should move as quickly as possible to secure new facilities before rates move higher. Tenants should always be looking for the right space because thin supply may preclude them from finding what they need when they need it.
We will do our best to keep you informed as we observe the actual impact of all these factors is measured. Stay tuned and stay informed.