Commercial Real Estate Headed for a Slow Down (article)
The improving economic conditions have created a near perfect environment for real estate over the past five years. Data collected by industry analyst IBISWorld shows that the commercial real estate sector grew at an annualized rate of 3.2% from 2013 to 2018. Industry operators also increased during that time by an annualized rate of 2%, and real estate employment rates recovered from the last economic recession.
Moving forward, the big story for the sector will be the impact of the federal interest rate increases. Interest rate hikes in 2018 slowed the sector’s growth pattern, but indicators suggest that strong performances in other key industry subsets will keep the sector on an upward growth trajectory through 2023. Below, we take a closer look at these primary economic predictors and their implications for the sector.
Private Nonresidential Construction and Consumer Spending
Private nonresidential construction values increased by annualized rate of 2.8% from 2013 to 2018. Values are projected to rise through 2023. Strong nonresidential construction values bring benefits for real estate broker commissions, which then affect other related real estate services in the sector.
Consumer spending is a strong predictor of economic strength, and it increased by an annualized rate of 2.9% from 2013 to 2018. It is projected to continue increasing, which will likely create more demand for corporate expansion and business development activity.
Vacancies in rental space are an indicator that there is an oversupply of nonresidential property in the market. From 2013 to 2018, office rental space vacancy rate declined by an annualized rate of 2.9%, which opens the door for potential new office space development in the coming years. Other types of commercial real estate are also seeing slight declines in vacancy rates, including retail and industrial spaces. Declines in vacancy rates are closely tied to the nationwide unemployment rate, which remains low and bodes well for future nonresidential property development.
10-Year Treasury Note Yields
The yield on 10-Year Treasury notes has a significant impact on commercial real estate entities. Credit is highly utilized in commercial real estate development, both to cover the cost of purchasing property and the cost of constructing new buildings. The increasing federal interest rate has made debt (and subsequently borrowing and lending) more expensive.
Commercial real estate felt the chilling effects of the four interest rate increases in 2018; growth declined by a projected 0.4%, leading to a loss of up to $1.1 trillion in industry revenue. As the economy slows, the Fed may forego interest rate increases in 2019; otherwise, the sector could continue to be negatively affected.
When companies have more profit and cash reserves at their disposal, they have a higher likelihood of investing in expansion projects, such as opening new locations or investing in property. Corporate profits did not follow a steady pattern over the past five years. Many companies had pared down their operations following the economic recession, and their lean operations helped to recover their cash reserves. But other macro events, including the decrease in crude oil prices and the appreciation of the U.S. dollar, led to corporate profit declines in 2015 and 2016.
It appears that corporate profits may be on an upward trend now. Perhaps fueled in part by the corporate tax cut in the 2017 tax reform law, corporate profits increased in 2018 and profits are expected to stay strong over the next several years.
Wages now take up a larger share of total industry revenues than they did in 2013. In 2018, wages accounted for approximately 14.6% of total industry revenue compared to 13.7% in 2013, according to IBISWorld data. It is expected that wages will continue to take up a larger share of total industry revenues moving forward.
Profit margins in some subsectors of the industry have also been negatively affected by new technology. New property appraisal databases offer automated valuation models, which reduces the demand for real estate appraisers. More websites are offering free real estate listing services, which affects the demand for brokerage firms and leasing and rental companies. These subsectors will need to adapt their service model to reflect the changes in technology and the availability of new data aggregation tools in the marketplace.
Multi-family Housing Development
Young adults are not buying homes with the same frequency as they did in years past, which fuels demand for apartment and other multi-family housing developments. The trend toward apartment living among the 20- to 34-year-old market is expected to increase nationwide in the coming years.
2019 and Beyond Outlook
Real estate values are expected to rise over the next five years, which will benefit real estate developers and related consultants. Continued increases in consumer spending will lead to more demand for retail space and other commercial activity and distribution centers. Growth areas are expected to counteract the potential negative effects of the interest rate and wage cost increases and technology trends, but the competing factors will make for a slower rate of growth for commercial real estate during the next five-year cycle. IBISWorld projects a 0.3% annualized growth over the next five years.
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