Last Tuesday, members gathered for breakfast and thought leadership at ULI New York’s Annual Economic Forecast, one of the District Council’s most popular recurring events. Law firm Kirkland & Ellis hosted the forecast, which was presented this year by Ken Rosen. Mr. Rosen is Chairman of Rosen Consulting Group, a real estate market research firm, Chairman of the Fisher Center for Real Estate and Urban Economics, and Professor Emeritus and California State Chair of Real Estate and Urban Economics at the Haas School of Business at the University of California, Berkeley.
Mr. Rosen discussed a framework for the U.S. economy at a high level and the talk included a discussion of the current outlook for a recession and commentary on the commercial real estate capital markets.
To cut to the chase, here were Mr. Rosen’s key points about how real estate investors can succeed, or at least hedge against losses, in 2019:
- We are at the end of the current cycle, and a recession is probably coming in mid-2020 to early 2021
- Cap rate compression is over, and cap rates will only increase from here.
- Real estate returns will come from Net Operating Income (NOI) growth and not from cap rate compression or value appreciation, so watch the cash flow from properties!
- Hedge your interest rate risk now while hedging is cheap due to the flat yield curve – lock in the low long-term rates!
US Economy at a High Level
The domestic economy is experiencing a true “sea change” in macroeconomic policy due to the combination of quantitative tightening (interest rates rising and will continue to rise) and the “sugar high” spending after-effects of the 2017 Tax Act. Mr. Rosen opined that, given the high employment level and strong economic performance metrices, a huge tax cut and adding a trillion dollars to the national deficit may prove in hindsight to have been unnecessary.
Two other trends from 2018 to watch going into 2019 are the uncertainty of a US-China tariff/trade war and restrictive immigration policies. These forces could further slow or weaken the national economy. 45% of US population growth comes from immigration, which Mr. Rosen pointed out distinguishes the US from other developed economies like Japan and therefore contributes to our economic competitive advantage.
The first half of the Trump Administration has also been marked by financial and environmental de-regulation. Mr. Rosen reflected that this could be mixed for the economy because, on the financial de-regulation side, business optimism has improved; however, environmental de-regulation is probably worse (or costlier) for long-term outcomes.
Risking Risk of Recession
The last recession was due to excess spending on housing. This cycle, Mr. Rosen pointed out that the greatest mispricing risk is the technology valuation bubble. While some companies such as Google and SalesForce show strong cash flows, there is a solid case that the technology sector is due for a correction because many startups are over-valued and will just not make it to the next cycle. In addition, the looming spectre of regulation to social media companies such as Facebook may cause pullback from investors.
Additionally, the 2018 Midterm Election adds another variable into the mix because the split controls of the House and Senate will cause legislative gridlock in Congress. Protracted hearings and political tactics, such as threats of a government shutdown or budget showdowns, will decrease the chance of consensus, helpful legislation or reforms passing, and other space for problem-solving.
Outlook for Real Estate Capital Markets
While many economic indicators are strong, such as consumer confidence and small business optimism, the US budget deficit is rising rapidly and will create a day of reckoning in the future. The yield curve, or the spread between short-term and long-term Treasury rates, has been flattening out this year and recently inverted for the first time in a decade, incidentally shortly after the economic forecast program. The phenomenon of inversion, in which short-term rates are higher than long-term rates (i.e. investors feeling more pessimistic about the long-term than short-term state of the US economy) has preceded every recession for the past 50 years.
(Even though every recession was preceded by an inverted yield curve, there is no guarantee of how much time lags between the inversion and the slowdown; during the Great Recession, the inversion happened 28 months before the recession began.)
With all of these factors in place, the Commercial Real Estate lending market is still awash in capital. Non-bank entities are still issuing plenty of loans, but not on construction loans. The “bid-ask spread” is still very much in force in the market, because investors are hesitant to deploy their abundant dry powder if a correction might be near; the prospect of being able to pounce and buy is slowing down dealmaking.
The major asset classes are in different phases of performance. Multifamily rent growth peaked at 6% annual growth in 2016. The Office market is mixed because, even in the face of job growth, there is less demand for office square footage per employee due to creative office layouts and other systemic changes in workplace trends. Due to this and the obsolescence of Class B/C space, there are persistent vacancy levels in the office sector. At the same time, Industrial is showing record low vacancies and anticipated 14% NCREIF returns for the year.
As ULI New York contemplated where the markets have been in 2018 and where they are going, in the face of political turmoil such as Brexit and war in Yemen, the attendees agreed the waters will be choppy in 2019 and investors will have to be very discerning and cautious in their underwriting.
Thank you to Brian Hwang of M&T Bank and Kyle Campbell of Real Estate Weekly for their assistance with the recap.