Summary of Real Estate Trends
February 10, 2020
By Joe Rubin
The Big Picture – Jobs, Yields and Capital
The real estate industry was bolstered by sustained economic and job growth and, more importantly, falling interest rates in 2019. Capital was abundant and fundamentals generally remained strong across property sectors. Property transaction volume was slightly lower than in 2018, but commercial mortgage origination volume rose as owners took advantage of historically low rates to refinance mortgages and finance property improvements. The overall outlook for 2020 is for continued stability barring an exogenous event that increases investors’ perception of market risk.
Every real estate discussion should begin with job growth, which is the catalyst for demand across property types. In 2019, 2.1 million jobs were created versus 2.8 million jobs in 2018. This decline was expected given the past decade of employment expansion. Lower job growth in 2020 should also be expected. The risk is that job growth falls below the approximately 1.8 million new jobs the country needs to break even; at that point, incremental demand for space would decline.
The 10-Year Treasury note yield, the most common benchmark for setting rates on commercial mortgages, began 2019 at 2.66% and ended the year at 1.92%, after reaching a mid-year bottom just below 1.5%. Rates have fallen further in early 2020 and, as of this writing, are at about 1.6%. These remarkably low rates made financing real estate cheaper and boosted investor returns. Such a significant drop in interest rates could have sent property valuations soaring. But the market showed some discipline and capitalization rates stayed relatively flat during 2019. The increased spread between capitalization rates and Treasuries has proven that there may be line in sand of pricing that smart capital simply won’t cross.
Nonetheless, equity and debt investor capital continues to flow into the real estate sector in abundance, albeit at a slower pace of new equity fund raising. Even at current prices, real estate provides strong relative returns, but those returns may not be enough to satisfy promote-driven private equity funds that are still sitting on hundreds of billions of dollars of dry powder. Foreign investors, for a variety of reasons that often depend on their own local circumstances, have started to pull back. While they pumped approximately $32 billion in new U.S. deals last year, they sold about $50 billion; resulting in net disinvestment. Canada, traditionally providing the largest inflow of real estate capital, slowed significantly. And China was more focused on disinvestment and capital repatriation than new deals.
It’s good to be a real estate borrower in 2020. If an equity investor can find a good deal, all loan types are readily available from an abundance of different lender types. In addition to traditional bank and life company portfolio lenders, debt funds and mortgage REITs grew originations in 2019. The commercial mortgage-backed securities (CMBS) market, only a few years ago considered irrelevant for its low volume, sprang to almost $98 billion in 2019, up 27% over 2018 and remarkably higher than the industry prediction of $71 billion last January. Fannie Mae and Freddie Mac broke records in 2019, securitizing over $100 billion of new multifamily loans. And more property owners, unable to find those good equity deals, are taking the defensive route and becoming lenders. Even the nascent collateralized loan obligation (CLO) market for commercial mortgages, used by many transitional lenders to finance their originations, rose 40% year over year to over $19 billion of new issuance in 2019.
The question, of course, is whether all this competition to make loans will change behavior and negatively impact loan credit quality. So far it appears that underwriting has held up. Loan- to value and debt service coverage ratios generally appear conservative, and are far better than at the peak of the last cycle. However, we mustn’t forget that the “V” in loan to value and debt coverage are bolstered by low mortgage rates. For the same reason delinquency rates remain very low for all types of loans. One wonders why borrowers still insist on (and lenders provide) full- or partial-term interest only payments (IOs) in this environment. Interest only loans made up over 90% of all CMBS loans last year, and full term IOs were 86% of originations. That’s significantly higher than during the crazy lending spree before the market collapsed in 2007, when full term IOs were 61% of originations. When these loans mature none of the balance will have been paid down, so an upward move in rates or deterioration in collateral performance could quickly squeeze equity. Credit watchers have also expressed concern over whether real estate lenders are lightening up on covenant requirements and conceding on “bad boy” guarantees.
Many banks, funds, owners and mortgage REITs are focused on financing “heavy” or “light” transitional loans, funding property renovations in the hope of improving value through higher occupancy and rent. The credit of these loans is highly dependent on the sponsor’s ability to execute renovations on plan and on budget, and the market’s willingness to lease the enhanced property at higher rents. As we get later in the growth cycle these loans become inherently more risky, with construction/renovation costs rising and absorption slowing. Missing plan would negatively impact returns to the borrower and may jeopardize a highly leveraged transitional loan. Industry participates have expressed concern that business plans have begun to take longer than projected to be realized.
Property Type Overview
Real estate investors are seeking yield and long-term growth, and they are much harder to find. With prices so high, they must search new markets and find hidden gems to achieve their goals. Overall, property trades were $570 billion 2019, slightly down from the previous year. There were fewer really big deals and the least M&A activity since 2013. Almost 75% of all trades were single assets, demonstrating how hard it is to achieve scale in this competitive investment environment. It should be noted that less than $20 billion of sales were for development properties. Real estate developers continue to show discipline in keeping supply in check, but of course at the top of a cycle new construction is a risky business. Banks are also reticent to fund land and new developments, particularly after the final rules for High Volatility Commercial Real Estate Loans (HVCRE) became effective. Banks must now hold 50% more capital for most land and construction loans, making them less profitable relative to other loan types.
Transaction activity in 2019 can be sliced many ways, and the most straightforward is by property type.
Economic and job growth continue to have a positive impact on office demand, especially since most of the jobs created are in the service sector. However, that demand is mitigated by more efficient use of space and more employees using technology to work remotely. Landlords have to offer more than just space to attract tenants who want to know about a building’s carbon footprint and demand amenities such as gyms, health and wellness centers, food outlets and cafes, and day care facilities. These requirements are especially important for the large tech companies who have become the biggest new tenants in many markets.
Almost $140 billion of office property was traded in 2019, slightly higher than 2018. Investors targeted secondary markets seeking higher job growth and yields. Charlotte, Nashville, Austin and Seattle had record transaction volume. Prices nationally were up about 4%, the lowest growth rate since 2013. CBD capitalization were little changed, ending the year at 5%.
The demand for flexible co-working space continues to increase from workers in the gig economy, small companies with fewer employees, and large companies not wanting to commit to long-term leases for large spaces. Co-working can be a win-win for landlords and tenants. So far, co-working space remains less than 2% of rental square feet, but has seen rapid growth concentrated in large urban markets. Perhaps too fast in some markets. Landlords (and lenders) are growing concerned that WeWork could represent shadow supply in certain markets that could suddenly be unleashed if the company fails to stop the bleeding, driving down absorption and rents. Rather than leasing to a co-working company, many building owners are keeping control of their space by fitting out one or two floors in a tower with flexible space.
The multifamily sector continues to perform well as renter demand remains strong, especially from millennials. Their love of flexibility and an urban life style may make them perennial renters, especially when their student debt loads prevent them from becoming buyers. Overbuilding in Class A properties has put pressure on rents and occupancy in many markets, while Class B and C “workforce” housing remain stable and the current target of many investors. Demand for multifamily property investments, often considered the best risk/return proposition in real estate, has continued to grow. Multifamily trades made up a third of all property trades last year. More than $185 billion of garden and mid/high-rise apartment buildings sold in 2019, a 4% increase over 2018 and an all-time record. Excluding New York City, where transactions fell by 44%, national growth was 13%. As with office buildings, investors were attracted to secondary markets, especially Las Vegas (which experienced the largest growth), Seattle, Phoenix, and Charlotte.
Despite all the activity, cash-on-cash returns have fallen and finding deals that pencil are harder; not every ‘fix it up to raise rents’ business plan will work. Equity investors are being helped by lenders eager to increase the share of multifamily in their portfolios. But many lender wannabes are being crammed out by Fannie Mae and Freddie Mac, which have already received their 2020 allocations from the FHFA and will likely originate close to $90 billion in loans.
Affordable housing is one of the most important social issues in the United States. There hasn’t been much talk about it in Washington so the states are coming up with their own regulations to address the problem. Most of these well intended regulations focus on controlling rent growth rather than incentivizing the construction of more units, resulting in developers and investors pulling back from the regulated states. This explains the fall in New York sales, which practically froze when new regulations were enacted mid-2019. Government officials and real estate owners share the common goal of providing quality apartments at reasonable cost, and they will have to work together to develop creative solutions to an issue that isn’t going away.
Senior housing remains popular among investors but there is growing realization that the baby boomers will avoid these housing arrangements as long as possible and the market will be oversupplied for some time. Student housing is similarly oversupplied in many markets after years of high-end millennial-focused developments that often make parents jealous of their children’s accommodations. Student deal volume fell 47% in 2019, and even Freddie Mac has indicated it is pulling back a bit. Both of these residential sectors need some time to restore equilibrium.
Industrial remains the darling of real estate investors, although many have been crammed out by the larger players aggregating multi-billion dollar portfolios. The demand for warehouse and distribution space to satisfy e-commerce appears insatiable. In 2019 over $110 billion of industrial properties traded, up 14% from the prior year. Almost half of those deals were portfolios of properties, including Blackstone’s purchase of GLP, which had already aggregated many portfolios. Average prices rose 12% in 2019, yet capitalization rates were flat. What changed was the spread between the capitalization rate and Treasury yields, which grew from 350 basis points in the fourth quarter of 2018 to 450 basis points in the fourth quarter of 2019.
Retail’s woes continue as consumer shopping patterns change and the sector slowly winds down a vastly over-stored America. Over 9,000 stores closed in 2019, a record rate. And the beginning of 2020 has brought a wave of new closings including bankrupt Papyrus shutting all of its 254 stores. Of course there are many types of retail, each with its own risks and rewards. Investors continue to target grocery anchored retail that provides the everyday staples that most consumers need. But even the stuff we buy locally is often as easily available online. Power centers remain a mixed bag with some retailers like Best Buy and TJ Maxx doing well and others like Pier 1, Bed Bath & Beyond, and Office Depot suffering.
Uncertainty in the life span of Sears, Penny, Lord & Taylor, and even Saks Fifth Avenue make owning malls a capital-intensive and sometimes losing proposition. Not all owners have the wherewithal to refit large areas, creating food halls, co-working space and health clinics where stores used to be. All of these strategies are in the experimental phase and have different levels of risk. The profusion of restaurants in malls appears a good short-term solution, but tastes are fickle -- and it wasn’t long ago when restaurant tenants were considered credit risk.
Trading volume in retail properties reflects these risks, down 28% in 2019 and only around 10% of the overall transaction activity. However, in 2018 GGP and Westfield were sold spiking transaction volume. Without M&A transactions, retail sales volume has been flat for three years. But digging deeper, sales of all types of retail were down in 2019 (and malls down 90%) with the exception of high quality single tenant properties (up 22%). Again, investors are looking for the bond type yield these properties provide.
Owners, operators, and lenders are watching the hospitality sector very closely. While disposable income is up and corporate travel is active, everyone knows hotels are the first to go in a downturn. Limited service hotels, whose numbers have grown like rabbits for the past ten years, are showing signs of weakness – they don’t really provide the kind of experience millennials are seeking. And those boutiques that millennials crave have also procreated so quickly that supply has overtaken demand in many urban markets. Lenders are beginning to see some cracks in hospitality credit.
The over-supply created from newly constructed hotels has been exacerbated by the almost two million additional rooms in the co-sharing systems of Airbnb and its competitors. Moreover, reservations booked through online services such as Expedia are stripping a slice of profits away from the industry. A 15% drop in transaction volume in 2019 is no surprise. Capitalization rates were up slightly to an average of 8.7% in the fourth quarter. As in other property types, investors are seeking safer havens in growing secondary markets, with significant deal activity in Palm Beach, New Orleans and Nashville.
Investment Considerations for 2020 – Hidden Risks
Real estate remains a strong investment opportunity. While bullish, investors are well aware that an unusually long growth cycle will have to come to an end at some point. With assets priced to perfection, there is little room for error and investors need to carefully pick their spots. Waves of capital could overtake fundamentals in driving excessive valuations. Looking forward, the key question is whether capital is being adequately compensated for risk. Many in the industry already believe risk-adjusted returns are inadequate in today’s environment; if risk perceptions change further, the market could turn on a dime.
What could cause such a change in sentiment? The simple answer is no one knows. But a swing from an up to a down market may have nothing to do with real estate itself, which remains in fairly strong supply-demand equilibrium in most markets. Rather, many risks are exogenous and uncontrollable including:
- The global geo-political environment is scary, with leaders waging trade wars and threatening real ones; growing instability could disrupt financial and energy markets causing spreads to widen across asset classes
- The U.S. markets have priced in a probable outcome to the presidential election; a surprising result could jolt investment spreads
- Financial system liquidity could erode and curtail lending; the Fed has pumped about $300 billion to money and Treasury markets in the fourth quarter, inflating the value of financial assets; if the Fed’s appetite for continued stimulus wanes, as is already indicated in early 2020, lending dynamics could
- Similarly, as central banks globally pull back on economic accommodation, interest rates may trend upward; in real estate a move of 100 to 200 basis points would severely impact investor yields and loans of recent vintage may not be able to be refinanced at higher rates unless property cash flows keep pace
- Environmental concerns are becoming more real each year; looking out at a ten-year investment horizon it’s possible that properties will be literally under water from ocean creep, rising rivers and storm floods, or incinerated by uncontrolled fires.
Any one or a combination of these events could convince equity or debt investors that they need to be paid more or they will move their capital elsewhere.
This is the time for otherwise exuberant real estate investors to use caution and resist the temptation to squeeze that last bucket of milk out of the cash cow. A sober look at each investment opportunity with detailed due diligence is more important now than at any point in the cycle. Of course that’s very hard in the midst of enormous capital competition. Investors need new deals to justify their existence and know others will likely grab deals when they hesitate. But smart money remembers the cyclical nature of real estate and looks beyond short-term wins. There is always another opportunity.
A proven real estate strategy has been to find profit in demographic shifts: Follow people and jobs. Migration to secondary sun-belt and tech-focused markets will continue to provide opportunities for both growth and yield. But in underwriting any deal, the old 3% growth convention may no longer work. Investors should consider stress testing their assumptions to determine the impact of a recession at some period within their five-to-ten-year hold. And remember: When everyone builds in the same growing market, at some point they’ve built too much; but nobody realizes it until it’s too late.
2020 promises to be a successful year for equity and debt players who are smart, targeted, and don’t get caught up in the competitive whirlwind.
 Source: Bureau of Labor Statistics
 Source: treasury.gov
 All transaction volumes, pricing and capitalization rate data in this article was sourced from Real Capital Analytics
 Security issuance volumes sourced from Commercial Mortgage Alert
 Source: Trepp
 Source: Barron’s