There are many factors that drive the commercial real estate market in the U.S., but conventional wisdom is that the key indicators to watch as benchmarks for the real estate market are: job creation, GDP growth, changes in long-term interest rates and creation of new supply in the relevant sector. Clearly, strong job creation and a strong economy (GDP growth) lead to strong demand for office and residential space, though the latter can also be affected by demographic and generational preferences (i.e. if millennials favor multi-family rentals over single-family homes as they become a stronger factor in the housing market due to their coming of age and retirment of baby boomers). At some point, increasing long-term interest rates and debt service costs will result in higher cap rates on real estate, so that, if all other things remain the same from a cash flow perspective, pricing would tend to decrease somewhat in a rising interest rate environment. These factors can also be affected by significant increases in supply in a particular sector and market, such as the recent large increases in Gateway market multi-family, notwithstanding strong GDP growth and job creation, has caused a decrease in net effective multifamily rents, though that decrease is expected to be short lived since that supply is expected to be absorbed over the next year or two, which would lead to a resumption in rental growth over time. Finally, I would add to these traditional indicators global capital flows as an important factor in pricing, especially in those markets and sectors that attract foreign capital. Much of the price increases and cap rate compression in Gateway markets for class A properties from 2013 to 2015 was the result of the tremendous surge of investment demand from PRC into the U.S., and the decline in those figures over the last two years has slowed demand and led to level, and in some cases, lower prices in certain asset classes in Gateway markets. In addition, the systemic changes in the U.S. retail industry caused by the rise in e-commerce and changing purchasing patterns by consumers (also causing a rise in demand and prices for well-located logistics and distribution facilities) is an undeniable force that is outside of the normal indicators for real estate markets, but equally noteworthy.
What is driving continued growth in the commercial real estate sector?
We passed on a couple of properties toward the end of 2017 because we thought prices might come down a bit in 2018. That obviously does not appear to be the case, as prices continue to rise. What are the driving forces for growth in the commercial real estate sector? How long do you anticipate those factors being in place?
I can only reply with the best information I have. People have been predicting falling prices for some time now. I think there are a couple of things driving real estate values. First, I do think interest rates will become an issue at some point. Current owners have refinanced and hedged interest rate exposure. I do think that a steep rise will have an effect, but I can't tell you when. Second, the U.S. real estate market is still attractive to foreign investors compared to Europe, where there is concern about a decline. So I think European money as well as Asian money will continue to look at the U.S. Koreans prefer debt to equity in any event, so they will not be put off by rising interest rates. Third, real estate is regional and different sectors perform as such. Industrial remains strong, healthcare as well. Office seems to be rebounding, depending on the market. Retail is far from dead. Hospitality is off. Anyone who gives you a definitive answer is as likely to be wrong as he or she is to be right. Pick a market or property type. Work with sophisticated advisors and keep your ears open. That is my best advice.