Some of the best minds in commercial real estate seemed a lot less worried at the 26th annual ULI/McCoy Symposium on Real Estate Finance, held in December in New York City. “It was a better tone than last year,” said Bowen H. “Buzz” McCoy, a ULI Life Trustee who founded the namesake event.
Although proceedings of this invitation-only event are not attributable to participants, McCoy and some participants agreed to share key takeaways. Their top message: investors keep pouring their money into office towers, apartment buildings, and other real estate in the United States despite high prices, worries that the U.S. economy could fall into a recession, and the uncertainty that accompanies a presidential election year.
“Real estate still looks attractive compared to everything else,” said Ken Rosen, chairman of Rosen Consulting Group, a real estate market research firm. “We pulled back from the brink of worry over the summer.”
Economists Still Worry about a Downturn
A year earlier, in December 2018 the experts participating in the McCoy Symposium worried that the U.S. economy had expanded for about as long as it could. In summer 2019, collapsing negotiations between the United States and leading trade partners roiled bond markets. However, by December 2019, the economic news seemed more positive, with tentative trade deals appearing to progress.
“Three months ago, we had a much higher possibility of recession,” Rosen said. However, even with a new, brighter outlook, he believes there is still a 35 percent chance that the U.S. economy will fall into recession in the second half of 2020. The odds of a recession go up even further—to 50 percent—by 2021.
“You can’t go too far wrong if you say that the longest recovery ever in the U.S. will eventually end,” McCoy said.
As 2019 came to a close, however, the U.S. unemployment rate was still near historic lows, and the economy was continuing to add jobs. And commercial real estate investors continued to benefit from low interest rates.
Nevertheless, economists and experts participating in the symposium still identified risks and reasons to worry. “There is too much debt in the system—from school loans to single-family mortgages and commercial real estate loans to the deficit in the federal budget,” McCoy said.
Underwriting standards for single-family home loans, in particular, have begun to deteriorate, he noted. “They are lending too much on the value of the property.”
Economists also worry that certain parts of the U.S. economy have become overvalued as its expansion continues beyond one decade of continuous growth. For example, only a handful of highly valued tech companies account for much of the total valuation of shares of stock in publicly held technology businesses. The spectacular failure of the WeWork initial public offering (IPO) in 2019 has raised worries about highly valued technology companies overall.
“I see a big correction coming in the tech sector,” Rosen said.
Investors Pay High Prices
Commercial real estate investors keep finding reasons to pay high prices for properties. The yields on their investments are still near historic lows—though these yields are high compared with the yields on many government bonds.
“With capitalization rates falling from a nominal 8 percent rate to 6 percent or 4 percent or even 3 percent . . . it is hard to rationalize that,” said McCoy. “Somebody is going to be left holding the bag.”
Despite high prices and low cap rates, many private equity fund managers have consistently provided strong returns to their investors throughout the recovery.
“You can’t keep giving 20 percent returns year after year after year without having something crack,” McCoy said. “These deals are so stressed for cash that when doing the pro forma the investors sometimes don’t leave room for capital expenditures to maintain the properties.”
However, many private-equity funds that target real estate investments also have raised billions of dollars that they have committed to spend on behalf of their investors. There simply are not enough real estate deals that make sense for these funds to deploy all that capital.
“There is lots of money on the sidelines,” Rosen said. “That stretches out the cycle.”
Investors continue to be drawn to invest in real estate properties because of strong demand from tenants. For example, industrial spaces such as warehouses have often been rented as quickly as developers can build them in key markets and submarkets. More customers continue to buy goods from online retailers that deliver products directly from those warehouses.
“Industrial real estate is still red hot,” Rosen said.
However, property prices are unlikely to rise forever, even for these most desirable spaces. “Warehouse space—that has been a great product,” McCoy said. “Like anything else, however, it corrects after a while.”
Demand for office space is also strong in many markets, including the West Coast and a few East Coast cities like Boston. However, in places like Washington, D.C., and New York City, developers have built too many new office towers. The new buildings are luring companies away from older office spaces, raising vacancy rates for class B buildings.
Because of all this competition, companies that rent office space are becoming more demanding. To attract tenants today, owners of existing office properties often have to spend more. At the same time, construction costs have increased, driving up the cost of building out office spaces.
“Tenants want newer, unique spaces to recruit and maintain top talent,” said one symposium participant. “The percentage of net operating income [NOI] that goes to tenant improvements and lease commissions and capital expenditures is higher.”
Many office landlords now must budget as much as 30 percent of the NOI from an office property for tenant improvements and capital expenditures. That is compared to just 10 percent for many industrial properties, he said.
To make sure they can afford to pay for these capital expenditures, many buyers now focus on office buildings that have embedded rent or market growth.
Many major office tenants also now prefer to locate in buildings that have short-term office space available for them to rent for special projects or accounts. The recent drama at coworking provider WeWork has not cooled demand for these kinds of flexible, coworking space in top markets.
Many retail properties are also still suffering from higher vacancy rates as more shoppers buy products online instead of in stores. However, investors now disagree about how to value retail properties, particularly shopping malls.
Private investors are often willing to pay higher prices and accept lower cap rates for mall properties than the cap rates implied by the prices investors pay for shares of stock in retail real estate investment trusts (REITs).
Sometimes the difference between the cap rates paid by private investors charted by the National Council of Real Estate Investment Fiduciaries can be as much as 150 basis points lower than the cap rates indicated by REIT stock prices, said Rosen.
“The public markets tend to focus on current negative news for retail properties,” the symposium participant said.
The experts at the symposium agreed that demand for multifamily properties is still strong. The percentage of rental apartments that are empty is still very low, on average, across the United States. However, in places like New York City, the market has been flooded with new, super-expensive for-sale condominiums. “The high-end condo market in New York City has a huge oversupply,” said Rosen.