U.S. economy: cautious optimism in the 21st century
As Europe and several key emerging markets struggle with a surge in COVID-19, the U.S. economy is showing signs of an imminent rebound. Although the first wave of the coronavirus may have sparked anxiety regarding financial stability and delivered a wealth shock as stock prices plunged, although briefly, financial conditions have eased appreciably since then. Unexpectedly, a growing stock market and rising house prices are now providing a wealth boost for some Americans. After surviving the rough waters of 2020, there’s light on the horizon, and while we’re not out of the storm, there’s a sense that in the second half of 2021, economic fundamentals will regain their footing as vaccines continue their rollout and employment trends in the right direction.
Non-farm employment is showing early signs of recovery, with the unemployment rate edging down to 6.0%. Although still 2.5% higher than the historic prepandemic low in February 2020, it’s a huge improvement over April 2020 when it peaked at 14.7%.1 Advances in leisure, hospitality, and food services led the pack, another sign that the return to normal might be closer than we thought.
Monetary policy is expected to be highly accommodative over the course of 2021, with U.S. Federal Reserve Chair Jerome Powell signaling that rates will likely remain near zero through 2023, barring an uptick in inflation, and that the central bank would pull back on purchasing bonds “well before” considering raising interest rates.
Monthly employment change and unemployment rate
Q1 market review and Q2 outlook
The global crisis hasn’t spared investment markets, but rather than the free fall first predicted, it’s been closer to a stall, with vaccine rollouts across the country a sign that activity may be speeding up. The pandemic only accelerated certain trends already occurring: Retail foot traffic was already slowing down, residential affordability in city cores was already pushing interest out toward the suburbs, working from home was becoming more routine, and industrial real estate was already red hot. One trend that’s taken on greater urgency is sustainable investing, and while environmental, social, and governance (ESG) has been a familiar idea for years, a focus on environmental factors is now tilting toward incorporating social aspects. With respect to real estate, accommodative monetary policy and availability of capital have helped stabilize property prices, and while transaction volumes have taken a hit and many investors remain on the sidelines, the pump is primed for activity once investor confidence returns. During the great financial crisis, property owners weren’t able to refinance easily, which led to forced sales and falling prices. This time around it’s a different scenario, as well-capitalized owners along with functioning debt markets have kept the wheels turning, if at a slower pace.
The multifamily sector continues to attract the bulk of investment dollars—preliminary data show US$32 billion traded hands in the first quarter of the year, a 47.1% retreat from the fourth quarter when excess demand was unleashed but registered only 20.9% below the average for the previous 20 quarters. Overall transaction volume was down 31.6% from the 20-quarter average, and while transaction activity was down for all property types, not surprisingly, office and retail, with few deals, were a big part of the story.2
At the outset of this year, apprehension was in the minds of many investors, with preliminary data supporting this; however, fundamentals are likely to improve. Typically, first quarters yield the leanest transaction volumes, so stronger investment activity may play out throughout the rest of the year. Potential positives for commercial real estate are that fear of inflation and preservation of capital demand could drive more investors to bump up their allocation to real estate, as this asset class is traditionally a good store of value.
U.S. commercial real estate quarterly transaction volumes
Source: Real Capital Analytics, as of Q1 2021. Preliminary data.
Demand for office space continues to decline as business closures and widespread work-from-home measures enforced at the onset of the pandemic are prompting occupiers to defer leasing decisions. National office net absorption confirmed the negative trend, reporting—45.4 million square feet (SF) in the first quarter, while construction activity continues to roll along, as government work restrictions haven’t really affected the sector—Q1 saw a modest 13.6 million SF completed, in line with historical averages. Vacancy continues to trend upward, reaching 11.9% in the first quarter, and with 72.9 million SF of new completions forecast for the remainder of the year, vacancy will likely climb higher.3
Office supply/demand fundamentals
Lackluster leasing demand has stirred up competition as landlords increasingly offer more inducements to get tenants into empty office space. Lengthy free rent periods and generous tenant improvement allowances are becoming the norm, even in the most desirable office markets. Office rents will likely remain under pressure over the next 12 months and beyond, although the impact is likely to vary by building class and proximity to core CBD markets. Because office lease contracts tend to be long term, the pandemic didn’t precipitate a drastic decline in rental rates following the global switch to working from home, so it’s fair to expect that rates haven’t bottomed out, and further contraction may lie ahead.
Office rent growth (%)
While quarterly construction activity was moderate, secondary metropolitan areas are leading the way in terms of net deliveries, with Charlotte, Austin, and Phoenix in the forefront, contributing 4.3 million SF in Q1. This may not come as a surprise, as the flight from dense downtown core real estate has been well documented throughout the pandemic. New York City, on the other hand—usually the leader in new office supply—barely cracked the top 10 in the first quarter. Transit-oriented markets have taken a bigger hit throughout the global crisis, but the Big Apple is expected to come roaring back in 2022 when 6.8 million SF is due to be delivered.4
Office space under construction (% stock)
On the surface, it seems as though office real estate is headed down a rough path to recovery, but there's a high degree of uncertainty as to what the office might look like in a postpandemic world. Throughout the crisis, many occupiers have made sweeping declarations about the death of the office and permanent work from home. While we do envision more flexible workplace arrangements, some of the loudest voices in the room have toned down their earlier proclamations, as it's become evident that the physical office still plays an important role in overall business strategy and operations. This is especially true for big tech companies—many of the largest players leased more office space during the pandemic. A flexible workplace strategy is expected to reduce the overall office footprint in the near term, but de-densification and more collaborative office design could see requirements expand down the line. Another factor is that office-reliant employment could continue to grow steadily, which could end up counterbalancing the effects of a reduced footprint.
Industrial real estate continues its remarkable run as the pandemic has ramped up demand and led to historic low cap rates. Employment in transportation and warehousing, as well as manufacturing, grew by 48,000 and 53,000 jobs in March 2021, underscoring the increased demand from users of industrial real estate. At the forefront of tenant requirements is proximity to labor and to dense population centers, as market fundamentals reach record-breaking levels.
Industrial supply/demand fundamentals
Net absorption surpassed 100 million SF in back-to-back quarters for the first time, as demand hit 100.2 million SF nationwide to start the year. This stronger-than-anticipated growth in demand outpaced new supply, with completions dropping to 57.4 million SF in the first quarter5—an imbalance in supply and demand signaling 2021 is likely headed toward posting another bumper year for industrial real estate.
Industrial under construction (% stock)
A differentiating factor is that real estate costs amount to a fraction of expenses compared with transportation and labor for most industrial users. In addition, the new priority of being close to customers to minimize delivery times and reduce environmental impact suggests there’s still room for rental growth going forward. The long-term nature of leases in this category typically causes rental growth to lag demand, which leads us to predict that rents will likely improve slightly in 2021 and jump up considerably in 2022.
Industrial rent growth (%)
All signs point to the current low-for-long interest rates persisting, which augurs well for future investment. Even with record-low cap rates, capital should continue to flow in the direction of industrial real estate, with the expectation that years of rental growth likely lie ahead. Many markets of size are dominated by institutional owners, so we could see interest pick up in secondary markets as private investors attempt to grab a piece of the action.
The outstanding performance of industrial real estate may seem unsustainable, but underpinning future growth are a few transformative dynamics. For one, as a result of supply chain disruptions experienced throughout the pandemic, we could see footprints expand as occupiers up their inventory levels and switch from a traditional just-in-time model to a just-in-case model. In addition, as China’s middle class continues to expand, industrial real estate will progressively shift from mainly export use to serving domestic needs, which may lead to onshoring and reshoring as supply chain costs increase, further benefiting North American markets.
One of the most publicized consequences of the pandemic has been the urban exodus, as renters flee small expensive downtown condos in search of less expensive, more spacious living arrangements in suburban markets.
Multifamily supply/demand fundamentals
The data supports this trend nationally: Suburban rents and vacancies were relatively unchanged in 2020, while urban rents plunged 12.1% and vacancies jumped 190 basis points to 6.1%.6
Multifamily rent growth
Multifamily differentiates itself from other commercial property types in one way—regardless of economic conditions, people always need a place to live. While the previous administration was slow to react, the Biden stimulus package allocates $45 billion to rental assistance. This is in addition to a recent announcement extending mortgage forbearance to multifamily owners unable to collect rent, which should shore up prices and prevent distressed sales.
The pandemic has also revealed a years-long trend of increased investor appetite for beds and sheds. In fact, multifamily led all property types with 36.2% of total investment volume in 2020, followed by industrial at 25.8%.7 And while top investment markets recorded declines year over year, secondary markets such as Jacksonville, Sacramento, and Salt Lake City posted solid gains, bolstered by strong demographics. Also of note, stable income and safety of capital make multifamily the favorite property type of foreign investors. So while 2020 saw international multifamily investment retreat to some extent, it’s likely to return in 2021 as the shock of the pandemic wears off.
The global work-from-home experiment, widely touted as a success at the onset of the pandemic, has been met with some resistance one year in. Tech companies, which were the fastest to react and best positioned to adapt, have changed their tune in recent months, signaling that a return to office may come sooner than expected. Employees who ditched their downtown apartments in hopes of permanent or partial remote working may find that even occasional commuting can counterbalance the benefit of suburban living, which would revive urban rents, especially in major office-driven markets.
Luckily, the residential construction industry—deemed essential—was able to continue its activity, as many parts of the economy were curtailed by government lockdowns, which led to a 20-year high of more than 450,000 units coming on stream in 2020. This productivity did come at a cost as construction starts dropped to 310,000 units, culminating in a relatively small pipeline of 3.2% of total inventory.8 Low expectations for future supply, however, should provide a boost to rental rates in the long term as the markets recalibrate demand to current and postpandemic levels.
Multifamily under construction (% stock)
1 Bureau of Labor Statistics, as of March 2021. 2 Real Capital Analytics, as of March 2021. 3 CoStar, as of March 2021. 4 CoStar, as of March 2021. 5 CBRE Research, as of Q1 2021. 6 CBRE Research, as of Q1 2021. 7 CoStar, as of March 2021. 8 CoStar, as of March 2021.
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