Report: Commercial Real Estate Well-Poised to Handle Economic Slowdown

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By Meghan Hall

Well into the current economic cycle, investors are watching their bottom lines and carefully analyzing which asset classes will prove most stable as the market matures, and eventually, corrects. According to a CMBS Second Quarter Market Outlook released by Morningstar Credit Ratings, commercial real estate is healthier and better poised to handle an economic slowdown and is less risky than the previous economic cycle, thanks in part to higher underwriting standards and steady economic fundamentals.

According to Morningstar, the past market cycle has been more moderate in several ways and has produced a more stable, and longer growth period. To start, the unemployment rate in the United States was standing at 3.8 percent, almost the lowest level in nearly 50 years and an indication of an economy that is still favorable. Additionally, states Morningstar, the current economy does not have the trappings of a normal boom and bust cycle, given that the cycle’s average annual gross domestic product growth rate is at 2.3 percent, close to half of the annual average witness over previous cycles.

“This shows there are no huge imbalances or signs of overheating in the economy, which usually precede a recession,” stated Steve Jellinek, Vice President of Credit Risk Services at Morningstar and author of the report. “The upshot of this slow and steady expansion is that it may prolong the current business cycle. Commercial real estate will benefit from this pace of growth. Demand for commercial space is strong, but not so robust as to spur excess lending and speculative new development.”

The current market cycle has also seen fewer troubled and delinquent loans. Ongoing liquidation of pre-2010 loans serve as the basis for falling commercial mortgage-backed security delinquency rates (CMBS). CMBS issuance has also slowed, as new issue volume dropped to $83 billion from a post-crisis high of $95 billion in 2015, due to competitive pressure from other capital sources and thinner profit margins.

With delinquencies low, more selective underwriting strategies and a steadily growing economy, Morningstar expects U.S. property fundamentals to hold steady across most types of commercial real estate.

However, the multifamily and industrial sectors are the two submarkets within the commercial real estate industry that are likely to see the most stability, the report states. Demand for multifamily housing is healthy due, in part, to the financial challenges of owning a home, with year-over-year rent growth accelerating in 2018 and vacancy rates hitting a multiyear low at 4.5 percent in 2018, states the report.

The accelerating growth of technology and e-commerce also continues to drive down industrial vacancy rates; according to Morningstar, industrial properties were second to multifamily in terms of net operating income (NOI) growth, increasing from 3.51 percent to 4.66 percent between 2014 and 2016.

“Changes to consumer retail habits and demands have led brands to seek faster delivery by positioning goods closer to urban centers,” Jellinek explains. “This demand has developers rethinking the warehouse and manufacturing industry, as seen with Prologis, Inc.’s multilevel warehouse in Seattle, the first of its kind in the United States.”

However, the growth of e-commerce has mixed implications for the retail real estate market. While many retailers from Toys ‘R’ Us to Payless ShoeSource Inc. to Charlotte Russe have announced store closures, retail sales continue to grow year-over-year, according to the National Retail Federation, which predicts sales growth in 2019 will be between 3.8 and 4.4 percent. Lenders for retail properties, according to the report, have altered their preferences toward lower-leveraged, high quality properties, resulting in CMBS delinquencies decreasing 17.8 percent in February 2019, a low of $5.75 billion.

Like the retail real estate market, Morningstar also identified some risk within the office market. While 37 million square feet of absorption is projected for 2019, Morningstar states in its report that large office tenants are frequently choosing not to renew their leases in order to move to newer, more amenity-centric developments coming online, increasing risk when it comes to commercial mortgage-backed securities. Further risk is added, says Morningstar, when factoring in increasing rates of new office supply over the next several years.

“Despite some worries about a market correction, continuing economic resilience in 2019 will buoy U.S. real estate fundamentals, which Morningstar expects to remain solid, as supply and demand remain in relative balance across all sectors,” states Jellinek. “In particular, the industrial and multifamily sectors will likely outperform office and retail because of the tailwinds from millennials and e-commerce sales.”

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