Are We in the Last Innings of the Real Estate Cycle?

On a national basis, the upward momentum for commercial real estate prices and values has slowed recently compared to the rate of increases we saw in the first few years after the credit crisis.  Now there are two things to keep in mind about this statement.  First, commercial real estate (CRE) values are still driven by the market area.  It is the old location, location, location thing.  Those in Williston, North Dakota, have not seen overall CRE increases in the past year with the decline in oil prices that hit the second half of 2015.  Also, we will begin to see ag land prices softening with lower commodity prices today than what was in place in 2013.  So the sector and location you are in will dictate if you are seeing upward growth in values like the national averages.

Second, the only time it is possible to time a peak in the market is in hindsight.  If you are able to forecast a market peak correctly, then you are pretty lucky.  So what we can understand is the influencers in CRE today and make preparations for the next steps of the CRE market.  In order to do this, we must try to figure out which innings of the market we are in today.  I use innings as we have spring training that is right around the corner for those baseball fans.

CRE has been an overall great investor performer and a preferred asset class since the end of the credit crisis.  Values were depressed in many areas, in some cases to the point of abnormality.  Investor confidence in CRE peaked in 2013 and has dropped since then.  In the third quarter 2016, CRE still remains slightly higher in investor confidence than stocks, with cash as a close third.  Confidence in bonds is relatively low as investors believe that higher rates are around the corner.  This drop in confidence indicates that we are entering into the later innings of the CRE uptick. 

A recent poll at the University of Chicago Booth School of Business Real Estate Confidence among real estate professionals asked where the industry is in the current cycle.  The professionals were asked to use a baseball analogy to characterize the inning of the CRE growth cycle we are in.  The result is we were in the bottom of the 8th inning in late 2016 and are entering in the 9th inning in 2017.  This year is expected to be much like 2016, with CRE prices and values on average increasing slowly and cap rate compression slowing down.  The questions are what are signs that we are getting close to the third out in the 9th and what are possible signs we can go into extra innings.

Interest rates are creeping up, which will curb the availability of loans for projects.  It is anticipated the Fed will continue on a course of slowly measured increases.   As rates do increase, we will see marginal financing projects become unaffordable.  Another factor to limit capital will be the new regulations in the CMBS market, with its billions of dollars of loans that will be maturing over the next few years.  Credit unions and banks will see an increased amount of refinance activity, but overall expect the supply of loans to slow with these changes.

Any possible black swan event could also lead to a major market correction and the end of the game.  This could be started from wide-scale terrorist attacks, a financial crash, or some other unforeseen event.  One would think that when such an event occurs, the market will act rationally.  However, with new players who have not experienced the Great Recession in the CRE realm and how irrational folks can get, it may not always have a smooth ride.

So what can take us into extra innings of CRE growth.  One large factor is the investor perception.  If people believe that things are improving in the future, they will be more apt to invest in CRE today.  We have seen an increase in the spirit in our country after the election which has been seen in major announcements of new offices and production facilities.  Another factor is the rise in the stock market.  Clearly, if a sizeable portion of the cash that has sat on the sidelines since the Great Recession begins to flow into the market, we will see extra innings. 

Another factor is fiscal policy reform.  This can come from both tax cuts and regulatory burden relief.  If Trump is successful in cutting corporate and personal taxes and also eliminating 2 regulations for every new one started, we will see the economy grow with the shackles of Washington loosened.  Accomplishing these things seem elementary simple to the average American in the heartland, but do represent a threat to the bureaucrat’s way of life.

Ken Riggs of Situs RERC Advisors sees industrial properties will still have the largest cap rates of any major property type.  We may see some price compression in offices and retail properties prices will slow.  Any property with a long term lease may look good to a lender, but will have more interest rate risk and lower values in a rising rate environment.  If the economy keeps growing, apartments and hospitality may be in the best position to take advantage to hedge out increasing rates. 

So back to our question, what inning of the CRE growth cycle are we in?  Are we in the latter innings?  And if so what factors could send us to extra innings and what means the game is over?  Unfortunately, this is not as clear as the third out in the bottom of the 9th is in a baseball game.  But we can see the influencers and make moves accordingly.